In business to business transactions, buyers generally take up to 90 days to settle their payable invoices, largely because of prolonged paper-based invoice approval processes, among other reasons.

This generally affects the suppliers negatively, especially SMBs, who may need the payment earlier to ensure healthy cash flows and keep operations afloat.

On the other hand, buyers want to reduce the total amount they pay on the invoices issued by suppliers.

To meet both these requirements, businesses leverage a solution known as dynamic discounting.

What is Dynamic Discounting?

Dynamic discounting, in finance, is an arrangement where buyers get a discount on their invoice amount by paying their suppliers earlier than the due date.

It incentivizes buyers to pay early by reducing their costs while giving the sellers a flexible option for receiving payments early in exchange for a discounted price on their goods or services.

The use of "dynamic" signifies the fact that the percentage of discount varies based on the date of payment. This means that the earlier the payment, the greater the discount will be.

A dynamic discounting solution can refer to a mutually agreed upon discount, depending on the settlement date, directly between the buyer and the seller or it can refer to an arrangement facilitated by a third party financing institution, wherein the buyer bears the financing cost in cases where the supplier avails the discounting facility.

In lieu of providing the financing facility and bearing the financing costs, the buyer may insist on a % discount on the purchase, depending on the date when the supplier discounts the invoice.

Example of Dynamic Discounting in Exports

For example, ABC, the buyer, purchases goods from a supplier, XYZ. The supplier uploads the invoice on the dynamic discounting system, and the buyer approves it.

Upon approval, XYZ calculates different offers based on how early they want to be paid. The supplier comes up with an offer of 2/20 net 60 days, which means that the buyer will get a discount of 2% on the approved invoice if they pay within 20 days with the maturity period of 60 days.

Now, the total amount to be paid by ABC was $20,000. If ABC pays XYZ within 20 days, they will have to pay $19600, so the buyer accepts the offer.

But, ABC was unable to make the payment within 20 days and decided to pay within 40 days of the total maturity period of 60 days. The supplier agrees to give a 1% discount on the entire invoice if paid within 40 days. The total amount to be paid by ABC then becomes $19,800. The buyer pays within 40 days and gets a discount of 1% from XYZ.

Dynamic Discounting VS. Supply Chain Finance

Both dynamic discounting and supply chain financing are techniques for improving working capital management.

In dynamic discounting, the supplier offers a discount to the buyer to pay their invoices early by agreeing to use cash on hand.

The discount offered will vary depending on how early the payment is made. Earlier the payment, the higher the discount.

Supply chain finance (SCF), which is also known as reverse factoring, also allows buyers to pay their suppliers quicker.

But in this method, a buyer will generally finance the early payment of the invoice provided by the supplier through a bank or another intermediary.

In exchange for the early settlement, the supplier will give a discount. The buyer then pays the bank or the other intermediary on the original invoice's due date or later.

SCF is beneficial for buyers trying to save their cash on hand.

In effect, dynamic discounting is a technique that is used within any given supply chain finance platform, including the one offered by Drip Capital and is not a separate product that is exclusive from other trade finance services.

What is the Difference?

  1. The buyer opts for dynamic discounting when they have cash on hand. On the other hand, supply chain finance is suitable when the buyer wants to make an early payment but wants to preserve cash on hand.

  2. In dynamic discounting, the buyer doesn't need to borrow funds from a bank or third party. Whereas in SCF, the early payment given by the buyer is financed through a bank or other financial institution. This financing is based on the buyer's creditworthiness, not the supplier's.

What are the Features of Dynamic Discounting?

There are certain characteristics of dynamic discounting that make it an attractive arrangement for buyers as well as sellers, such as:-

  • Early Payment By getting early payment, a supplier can reduce the average days taken to receive payment after a sale and boost their working capital.

  • Discount By offering a discount on the invoice, a buyer enjoys the benefit of reduced price payment, and the seller gets quicker access to money to improve their cash flow.

  • Ownership In dynamic discounting, the supplier has complete control over their invoices, as opposed to third-party financing organizations like banks and factoring companies.

Who uses Dynamic Discounting?

Generally small businesses use dynamic discounting when they want to either buy at discounted prices or have their accounts receivables settled early.

Supplier Payment Terms

Before delving into exactly the types of dynamic discounting, it is important to understand what supplier payment terms are, how they are mentioned in an invoice and how to interpret them.

As defined by Accounting Tools;

“Accounting payment terms are the payment rules imposed by suppliers on their customers.”

The payment terms listed in the invoice incentivizes a buyer to make early payments against the goods purchased by them with the variable component being the days from the due date of the invoice.

A typical payment term in an invoice appears in a format similar to this:

2/10 net 60 EOM

What are The Types of Dynamic Discounting?

There are two types of dynamic discounting options:

  1. Static Discount Static discounting is when a fixed discount is offered if the payment is made within the specified number of days.

Here the discount percentage remains the same regardless of the number of days by which the payment precedes the specified days.

For instance, if a 2% discount is applicable for payment within 10 days, the buyer gets the 2% discount whether the payment is made within two days or nine.

The most common discount terms provided are 2/10 net 30 or 2/10 net 60. For example, if a buyer agrees to 2/20 net 60, then the buyer must pay the entire invoice price within 60 days. If the buyer pays it within 20 days, say, within 7 or 14 days, they will get a discount of 2% and will only have to pay the remaining 98%.

  1. Sliding Scale In a sliding scale or linear discount, the discount rate varies based on the number of days by which the payment precedes the specified due date. The difference in the discount rates for different days is based on Annual Percentage Rate (APR) determined by the seller. This APR is multiplied by the number of days by which the payment precedes the due date. For example, a supplier offers sliding scale dynamic discount at 10% APR and wants the payment 60 days before the invoice due date. If the buyer pays 60 days early, they get a discount of (10%/365) X 60 = (0.1/365) X 60 = 1.64%. If they pay only 30 days early they get a discount of ( 10%/365) X 30 = 0.82%. Thus, the percentage of discount decreases along a sliding scale until it reaches zero on the actual due date.

How does Dynamic Discounting Work?

There are different ways a dynamic discount process can take place, but generally, it will follow these steps:-

  1. The buyer purchases goods or services and the supplier issues an invoice.
  2. The supplier proceeds to upload the invoices on the procure-to-pay (P2P) or dynamic discounting platform.
  3. The buyer proceeds to review the invoice issued and approves it.
  4. After the buyer approves it, the supplier calculates different offers for different early payment dates.
  5. The supplier chooses the best offer and proposes it to the buyer.
  6. The supplier receives the payment on the selected date.

Benefits of Dynamic Discounting

Both the buyer and seller can benefit from dynamic discounting in the following ways.

Advantage to the Buyer

  1. Risk-free Returns Offering dynamic discounting allows buyers to effectively invest their cash surplus in procuring discounts. This provides greater risk-free returns than traditional investment methods.

  2. Cost Savings Buyers can reduce the cost of goods and services by reaping the benefits of early payment discounts. This helps to support or strengthen their procurement key performance indicator.

  3. Improves Supplier Relationships Offering early payment to the supplier helps to show the buyer's creditworthiness and commitment to the relationship. This, in turn, strengthens the relationship between them.

Advantage to the Supplier

  1. Boosts Working Capital Suppliers can reduce the average days taken to receive or collect payment after sales (DSO or Days Sale Outstanding). This helps improve their cash conversion cycle, which can then be used to cater to another profitable order, without having to avail lines of credit, bank loans or inventory based loans.

  2. Low-Cost Funding Suppliers can gain access to funds at a lower cost than other choices available through dynamic discounting. This enables them to invest in growth or work out any unforeseen expenses.

  3. Enables Accurate Forecasting It is easier to forecast cash flow because the suppliers know when they are going to be paid.

  4. Allows for Invoice Selecting Dynamic forecasting gives the flexibility to select which invoice they would like to finance and give discounts on. They can decide if they want to finance all, some, or a specific invoice.

What is the Disadvantage of Dynamic Discounting?

Although the buyer receives a profitable price on the invoice and the supplier gets an early payment, the supplier is also at a disadvantage. By providing a discount on the entire amount of the invoice, the supplier does take a hit on their profitability.

Thus, the supplier should review their finances and opt for a dynamic discounting program only if the benefits gained from the improved cash flow outweigh the hit to the profitability.

How Does Dynamic Discounting Differ From Other Solutions?

Traditional methods of funding compare to dynamic discounting in the following ways:

Dynamic Discounting Vs. Factoring

When a seller factors an invoice, they are selling it at a discount in exchange for instant payment of 70-90% of the invoice amount to a third party. The factor pays the seller the remaining invoice balance minus its fees after the buyer pays the invoice price. A factor generally charges a flat rate of 1-4% and charges extra interest based on when the factor buys the invoice and when the buyer or customer pays the invoice amount. This leads to the fees adding up. However, in dynamic discounting, there is no advance rate.

The seller can have the buyer pay the invoice early, which will boost their cash flow as it will release their remaining funds. Also, the seller has complete ownership of the invoices in dynamic discounting, and they get the entire amount on their invoice minus the discount they provided to the buyer.

Dynamic Discounting Vs. Line of Credit

In lines of credit, a limit is set by the bank during the process of approval, and withdrawing the funds reduces the amount of credit available.

Even though a line of credit provides flexibility, it also requires personal guarantees and involves certain invasive rules or agreements. In contrast to a line of credit, dynamic discounting doesn't need any maintenance fees or balance to pay and is easy and quick to use.

Dynamic Discounting Vs. Asset-Backed Loan

Asset-based loans (ABL) are taken against receivables (amounts owed to businesses) and, at times, against their inventory. These loans are availed under asset-based lending.

Generally, ABL requires a personal guarantee with strict rules and agreements, which can be viewed as more demanding than lines of credit.

A bank may also ask for daily, weekly, or monthly reporting to ensure the loan amount isn't exceeding the collateral value.

Even though ABL is less expensive, it is not as easy to receive as dynamic discounting. ABL requires the entire business to be used as collateral to access the benefits of asset-based loans.

Drip Capital’s Dynamic Discounting Platform

Importers in the United States can use Drip Capital’s dynamic discounting platform that allows multiple suppliers to secure funds against their invoices prematurely.

In cases where suppliers avail a premature drawdown against their invoices, the buyer will enjoy a discounted price discounted price as per the supplier payment terms mentioned in the invoice.