Dynamic Discounting a Cash Flow Alternative
Dynamic discounting is more than simply another buzz word or social media catch phrase. It is a method that uses the economic realities to increase the cash flow of a business and gaining more control of the purchasing cycle. There is a simple mathematics to the process, and once it is carefully considered it brings huge advantages to an organization from both a purchasing and a cash flow angle. With dynamic discounting, cash flow is increased when an organization receives discounts gained by offering early payment to its suppliers.
Consider the payment terms of traditional discounting – 1 percent if paid within 10 days, net 30. There is a window of 20 days where neither the buyer nor the supplier benefits from making a payment. That results in lost cash flow for the supplier and no incentive for the buyer to pay until the last minute. For the buyer, if they were able to receive some type of discount within that 20 day window, it would provide an incentive to pay earlier.
Electronic invoicing is essential to the process of dynamic discounting, as manual processing of invoices is far too time consuming. Early pay discounting is only possible when accounting systems can be guaranteed to process the invoices faster than they are accustom (and contracted) to. The sooner invoices are processed, the more time will be available for the information to be processed and steps taken to maximize the potential of dynamic discounting.
The biggest incentive for the supplier to pay less and get paid earlier, is the area of cash flow management. The current method for sellers to use in managing their cash flow is factoring. Factoring is simply a third party lending the money due on the seller’s receivables, generally about 80 percent of its value, to the seller while waiting for payment from the buyers. What is overlooked by the advocates of factoring is that it omits the parties to whom they are selling as part of the solution.
In consideration of dynamic discounting, if the sellers can get paid sooner by their buyers, it would reduce the need for borrowing 80 percent of the value of the merchandise sold. That borrowed money comes with an interest rate attached to it, and is where the economic factor of the dynamic discount comes in. When interest rates rise, so do borrowing costs. The usual course of business is to pass along those increased costs to the buyer, which makes perfect sense to the seller because the buyer is the logical party to absorb the increased costs of doing business. But the alternative solution is to simply borrow less, and reducing the amount of interest paid.
Sellers do not have to give unreasonable payment terms to the buyers. One of the best approaches is to staircase the discounts, offering say 3 percent for a net 10 payment, then reducing the discount to 1.5 percent after 15 days. This is just an example, but illustrates how dynamic discounting can work to increase a seller’s cash flow and benefit the buyer as well.
Considering the existing advantages in using factoring and the supply chain financing (SCF) system associated with it, the major argument is that the supplier can take advantage of the credit rating of the supplier’s buyers to get excellent financing terms for their loans on accounts receivable. Though dynamic discounting does not negate this advantage, it does pose the question to the seller of whether buyers will be able to continue to do business with them during times of high interest rates. Rather than eliminating the need from third party loans while waiting for payment from buyers, the seller can continue with the existing SCF system while working with buyers to increase their cash flow. Having multiple sources of cash flow is a better way to improve cash management.