Much has been written about the advantages and disadvantages of offering early settlement discounts.
The arguments in favour usually focus on the ease of implementation, the benefits of accessing working capital and of reducing customer insolvency risk by obtaining early payment. But the math underlying these arguments often doesn’t add up, and usually assumes businesses operate in a perfect world.
In the real world, early settlement discounts can prove a hit and miss strategy at best. The main problems are as follows:
- There are often cheaper solutions for accessing working capital.
- It is also common practice to stretch out settlement dates beyond the payment terms by a few days – sometimes weeks and still pay the discounted rate. Policing this is expensive and risks alienating the client.
- Customers often short-pay invoices. It is standard practice for customers to take the discount on the total amount of the invoice (which includes tax and shipping), leaving suppliers to pick up the tab.
- The discount may need to be significant in order to receive satisfactory take up, cutting deep into a business’ margins
- Some customers use the early settlement discount to trade for more favourable terms on other fronts such as price, claiming the time value and interest cost to them in paying up front. This means suppliers pay twice.
Indeed, a whole industry has developed around providing advice on taking advantage of early settlement discounts. I quote one headline: “Don’t forgo early payment discounts: the returns are astounding”. This online article notes that that taking advantage of early settlement discounts is particularly a good strategy for low-margin companies.
This being the case, the logic flows that, on the flipside, discounts are a particularly poor strategy for low-margin suppliers. Discounts cost money so when costs blow out, low-margin businesses are hit hardest.
Having to endure all of the above complexities might be acceptable if supplier discounts were the only option available to business to improve cash flow, or even if it were the cheapest option available, but it’s not. One such alternative is debtor finance.
The table below shows that debtor finance is often a much cheaper, more efficient working capital alternative to discounts. The table provides three scenarios comparing the costs and savings of using a debtor finance facility with debt turns of 30 days and 45 days over a 12-month period to those of supplier discounts of 2 per cent.
Early Settlement and Debtor Finance comparison chart
These figures do not even include the time and cost of policing and administration, which can be more expensive still. Allocating payments to a debtor for a short-paid invoice, then chasing for the balance can be time consuming and aggravating to the debtor to the point where it is not efficient to do so, which in effect amplifies the discount granted .The GST, for example, proved a huge windfall to the Federal government and the main gain was to be had through ease of policing and savings on administration. A facility such as debtor finance offers similar “lever-style” efficiencies and financial gains for business.
This does not mean there isn’t a place for early settlement discounts. The main benefit is to reduce customer insolvency risk – to get your money ahead of other people in case there’s not enough money to go around. Unfortunately, there is no guarantee that early settlement discounts will solve this problem. But if a business has a debtor finance facility in place, it will have more headspace to focus on retrieving the funds and generating more revenue in the event of a default, rather than diverting valuable resources to putting out cash flow fires.
Nor does debtor finance preclude the use of settlement discounts. A business can easily use debtor finance to fund a percentage of invoices while focusing on one or two big, easy to process debtors that may lend themselves to an early settlement discount (typically companies that aren’t solid credits).
If in doubt as to whether your supplier discounts are working in your favour, always do the math – and don’t forget the administration costs.