Working capital management is a critical facet of any business. According to Economic Times, poor working capital management is one of the most common causes of failure among Indian companies. So, it is no wonder that these companies use various measures to ensure that they are able to maintain a healthy working capital position in all market conditions. Proper working capital management allows a company to strike the right balance between liquidity, growth, and profitability.
One of the most classic examples of working capital management can be seen in the payment of an invoice in an ordinary business transaction involving two parties – a buyer and a supplier. In most cases, the buyers wait until the last day to remit the payments to extend their payable days to optimize the working capital cycle. In other words, the buyers want to hold on to the cash for as long as possible as there is no real reason for them to make the payment before the due date. It is contradictory to what the suppliers want to do. The suppliers need to lower their receivable days to optimize their working capital and improve profitability.
So, both parties have contradictory stances on the same business transaction. Fortunately, there are working capital financing methods that can eventually result in a win-win situation for both parties. This article will discuss two such financing options – dynamic discount and supply chain finance, which the buyers and suppliers can use to achieve their respective goals of optimized working capital. So, let us start.
What is Dynamic Discounting?
on the purchased goods and services only if the latter can pay the invoiced amount before the due date. Typically, the discount is expressed as a percentage of the invoice amount. The size of the discount is contingent on how quickly the payment is made.
Unlike traditional early payment discounts, it offers dynamic pricing and discounts; hence the name dynamic discounting. Effectively, the buyer can pay at any time between the invoice date and the due date: the earlier the payment, the sizeable the discount. However, the supplier decides which invoices are suitable for an early payment discount, and the flexibility of the payment is also at the supplier’s discretion.
To avail of the benefits of dynamic pricing and discounts, the buyer must have adequate cash available that does not generate any significant return. In short, if the buyer has a large amount of unutilized cash, then dynamic discounting is a feasible option to reduce the cost of goods sold (COGS) and boost profitability.
What is Supply Chain Finance?
A third-party financer provides funds to finance supplier invoices in supply chain finance. In other words, the supplier receives the payment for the invoice immediately from the third-party financer instead of the buyer. So, now it is the buyer’s responsibility to pay the invoice amount to the third-party financer as per the payment terms.
Typically, the option of supply chain financing option is used when a buyer doesn’t have enough cash flow available to make the early payments and intends to extend the payment terms to optimize the working capital cycle. On the other hand, it results in quick settlement for the supplier.
However, one of the biggest downsides to supply chain finance is that it is usually available against buyers with healthy credit ratings. Hence, only a very few suppliers are able to avail of this option. Many suppliers are not offered supply chain finance because of their size.
Dynamic Discounting vs Supply Chain Finance
These are two different solutions for the same working capital issues. Two major differences between dynamic discounting and supply chain finance are:
- Source of funds: In dynamic discounting, the buyer itself finances the early payment of the invoice amount. In supply chain finance, the early payment is sponsored by a third party who the buyer later pays back on the due date.
- Buyer’s financial benefit: The buyer can reduce the COGS and boost profitability in dynamic discounting. The buyer can improve its working capital by optimizing payment terms in supply chain finance.
Which is a better option between Dynamic Discounting and Supply Chain Finance?
The answer to this question largely depends on the buyer’s cash position.
The option of dynamic discounting makes sense if the buyer has surplus cash and wants to boost profitability. It is a relatively low-risk financing method, and there is a high probability that many suppliers will be willing to offer discounts in exchange for early payments.
On the other hand, if the buyer wants to have access to working capital for an extended period, then supply chain finance seems to be a better option. In this case, the supplier gets paid immediately, while the buyer can hold the payment until the due date. But this option is available to a small number of suppliers based on size and buyers’ credibility.
A Bit of Advice
If you choose one financing method over another, you may find yourself boxed into a solution that will partially cover your business requirements. So, a blend of dynamic discounting and supply chain finance suits your business interest better.
Now, you can work with two different service providers for the two different funding models. But it will require separate provider agreements and may result in disjointed supplier experiences. In short, it may be an inefficient setup.
Fortunately, there is another option wherein you can give your suppliers flexible funding options on the same platform. Under YubiFlow, an end-to-end trade and supply chain platform, Yubi offers multiple funding solutions, right from vendors financing to dynamic discounting. So, instead of being pigeonholed into any one financing model, you can shift between several funding solutions as per your business needs without impacting the suppliers and the internal processes.