The benefits of factoring are well documented. Factoring is a great way to improve your cash flow, relieve stress and free up cash for new business development. It allows you to outsource credit assessment and some collection functions to a third party. It gives you the ability to focus on what’s important in your business.
Factoring is sometimes referred to as invoice discounting. The terms are used interchangeably from time to time. When you hear someone talking about invoice discounting, they’re probably referring to this type of receivables financing; however, there’s something else called a prompt payment discount that is often confused with invoice discounting.
What is a Prompt Payment Discount?
A prompt payment discount is an incentive to get your customers to pay faster. An example would be terms offering a 2% discount if the invoice is paid within 10 days. You may have seen this on an invoice as 2% 10, Net 30 or 2/10, Net 30. This means that if the invoice is paid within 10 days, a 2% discount may be taken.
Discounts can range from 1% to as high as 10%, but high discounts are uncommon outside of a select few industries. Most discounts offered are under 5%.
Why Would I Offer a Prompt Payment Discount?
At first glance the idea may seem crazy. Why would you accept less than the amount you’ve invoiced for? Why would you offer your customer a discount for doing what they’re supposed to do? Here’s the key – and this is huge - prompt payment discounts increase the speed of your accounts receivable collection.
How does this help you?
It helps in the same way that receivables financing does. It frees up capital so that it can be used for more productive tasks, like new business development. Capital that‘s tied up in accounts receivable provides no immediate benefit to you.
Accounts receivable is a number on a balance sheet. It’s an indication of future cash inflows, but it provides no benefit in this moment. The quicker you receive payment on an invoice, the quicker that number of paper turns into a tangible medium of exchange that can be put to work in your business.
What if I handed you an IOU for $1 million? That would be great right? But, if I never made good on that promise, if I never actually paid you, that IOU wouldn’t do you any good. An invoice is an IOU. It does nothing for you if you can’t collect. The cliché saying that ‘cash is king’ is apt. Cash is all that matters at the end of the day. Prompt payment discounts get you cash quicker.
How Can Prompt Payment Discounts and Factoring Work Together?
It may seem counterproductive to use factoring and offer a quick pay incentive at the same time. When you factor an invoice, you get cash as soon as you invoice. Factoring solves the cash flow issue discussed above. Why does it matter if the customer pays quickly?
Most factors’ fees are based on the number of days that an invoice is outstanding. An invoice paid in 10 days would incur a lesser fee than one that was paid in 45 days. Depending on your pricing schedule, the fee difference may be a couple of percentage points.
When you incentivize your customers to pay factored invoices within 10 days, your out-of-pocket cost is the amount of the discount plus the factoring fee. If the sum of these two is less than the fee you would pay if the customer takes full-term to issue payment, you save money.
Money saved is cash in hand, right? It goes back to the discussion above. Cash gives you the ability to run and grow your business. Invoice discounting/prompt payment discounts and factoring go hand in hand with getting your business cash as quickly as possible.