Dynamic Discounting 101 & Why Should You Care: Unlock Your Cash Flow Now (Part 2)
(originally posted here)
Because PG&E saved $74 million in 2011 & 2012 through Dynamic Discounting alone, with just one single Accounts Payable support employee for every billion dollars spent. And it got their supply chain paid within term. Now do we have your attention?
The Crisis: Cancerous Cash Hoarding
Eh. What’s The Problem, Doc?
Time and again, as Hummingbill analyzed the various factors behind late business payments as a phenomenon, cash hoarding by clients was constantly at the top of the list. And the numbers bear it out.
In 2015, 38.8% of SMBs in India stated that late payment by clients was intentional as an alternative means of financing their businesses by retaining free cash reserves. This was matched by 36.5% of SMBs in the United States who claimed late payments by clients were a way to use trade credit to ease the immediate demands on their working capital.
On the client side of things, free cash reserves in the BSE 500 (Bombay Stock Exchange; excluding banks and financial services firms) grew 11% year on year (y-o-y) between 2013-14, and another 12% y-o-y between 2014-15.
Among clients in the United States, American businesses are collectively hoarding more than $1.9 trillion in free cash reserves. In particular, General Motors holds nearly half its value in cash at any given point of time, while Apple holds a third. This global cash-hoarding epidemic is intensely real. And it’s growing worse each year.
So Why Should I Care?
Because the more your clients are inclined to hoard cash reserves as a business practice, the more late payments you face as an SMB/SME.
Ladies & Gentlemen, we have officially entered the age of business where your client owing you money for goods or services rendered means very little, if you want to actually touch that money before your business goes kaput. You have to actively provide a greater incentive for them to pay you on time, than the benefits they would enjoy from simply holding on to that cash for another 90 days.
And few practices are better at unlocking that cash flow right away than Dynamic Discounting.
Dynamic Discounting 101
What Is Dynamic Discounting?
Firstly, no matter how cool the term “Dynamic Discounting” sounds, it’s not some futuristic sci-fi algorithm designed by SkyNet to maximize your business efficiency. It’s just a self-adjusting discount scale set directly between you and your buyer.
In Dynamic Discounting, your buyer decides an annual percentage rate (APR) which would work for them. This APR typically depends on how much interest percentage they would enjoy if they simply let their cash hoard sit untouched, the economy of the geographic region in which both of you operate, the size of your business’ contribution in their supply chain, etc.
Different suppliers typically end with different APRs, unless the buyer fixes APRs on a tiered categorical basis, rather than an individual basis. That means 3 suppliers of roughly the same size in the same geographical area might get the same APR, unless one of them has more leverage in the business relationship because of the nature of goods or services supplied.
Once the APR is set between you and your buyer, you can approve selective invoices for Dynamic Discounting. After these terms are set, the total discounted amount then depends on how soon or late your client clears the overdue accounts receivables.
Dynamic Discounting vs Static Discounting
Static Discounting
Let’s take an example to compare and contrast the two styles. In Static Discounting, a typical agreement would look like this: 2%, 10, Net 30. This means that the seller is offering a 2% discount on the invoice if the client clears the overdue accounts receivables on Day 10 from the date of issue of invoice, where the contractual term is for payments within 30 days from date of invoicing.
Now the problem with that is – If the buyer is ready to pay on Day 2, they would still wait for another 8 days before making the payment because they have zero incentive to release that cash any sooner than they have to in order to enjoy that discount.
On the other hand, if they can’t make the payment on Day 10, but would gladly do so on Day 15, they still wouldn’t pay before the full 30 days are up because there is no longer any incentive for them to clear the invoice between Days 11 to 30.
In fact, since it’s almost impossible to collect late payment interest fees from clients who don’t want to pay it, without spending a lot of time and money in courts, they may as well let it sit in their cash reserves for another 40 days.
There are seldom instances of suppliers providing more than one discounting term for the same payment period as well. So, Static Discounting simply leaves a lot of wasted potential to get your cash flow back in shape by getting paid any of the other days within the payment term.
Dynamic Discounting
On the other hand, Dynamic Discounting requires minimum fuss from your end as a supplier, but leverages the entire payment period while providing incentive for the buyer to pay on every single day of the term.
Let’s assume the buyer set an APR of 24%, and the payment term is Net 30. Before we proceed, there is no such thing as a typical or average APR, since that differs from business to business and may range from as low as 2% to 25% and above.
With an APR of 24%, if the buyer decides to pay on the date of invoicing itself, then the discount amounts to:
[(APR/365)*Days Remaining Till Due Date], which would be
[(24/365)*30] = 1.97%
However, if the buyer decides to pay on Day 12 or Day 24 of the payment period, the discount amount would automatically adjust and scale back to 1.18% or 0.39% respectively.
Thus, Dynamic Discounting grants buyers the power to calculate the best returns for their business, and determine the optimal time within the payment term where the benefits of clearing the invoice would outweigh the appeal of cash hoarding. And as we mentioned at the beginning of this article, this process alone saved the Pacific Gas & Electric company $74 million in the two years of 2011 and 2012.
Unlock Your Cash Flow Now With Dynamic Discounting
In the end, Dynamic Discounting requires both buyers and sellers to appreciate the benefits of having a self-adjusting discount scale. For buyers, it provides the comfort of calculating the optimal period in a payment term where cash hoarding would yield less benefit. At the same time, it significantly improves relations with the supply chain.
On the supplier side, you get paid much faster so your cash flow remains healthy. Instead of looking at the typical payment periods of 30 to 120 days per invoice, depending on the client, you get paid within the first 30 days itself.
And, more importantly, you get your accounts receivables cleared with possibly far less discounting than you would have had to accept had you factored the invoice.
Additionally, all this happens without a third party provider mediating your payment relationship with your own clients. Since it’s a direct discounting approach, without need of banks, other lenders, short-term credit providers, factors, etc. you leverage your own business relationship to unlock your cash flow and get paid faster.
Now that we’ve surely convinced you of the awe-inspiring powers of Dynamic Discounting (DD), join us next time as we explore the different types of DD and see which ones best fit your discounting approach versus your need to get paid faster.
Let us know in the comments section – What has your experience with Dynamic Discounting, or even discounting in general, been like? What insights would you share with our readers and visitors from your experiments with this process?
In the meanwhile, Hummingbill takes care of all the other reasons you get paid late, from automated reminders to error-free, 1-click, e-invoices made in Gmail. So, sign up today for a free account with Hummingbill, or join the 14-day free trial with access to all of our advanced features.
[Click here to read “Unlock your Cash Flow Now: Part 1 – How to Calculate DSO”]
- Aniket Saksena & Adam Walker