What is Reverse Factoring?
Reverse factoring is a finance strategy where a supplier receives early payment for invoices from a third-party financial institution. The buyer then repays the financing company on its scheduled due date.
The financing structure helps sustain supply chain production. It’s sometimes called Supply Chain Finance, although that’s also an umbrella term for several forms of financing to help keep the supply chain moving.
The supplier’s early payment, which is essentially a cash advance, comes at a discounted rate. The discounted percentage is how the financing company makes a profit.
Early payments provide suppliers with working capital to cover day-to-day expenses. The buyer then has the freedom to wait until the invoice maturity to pay while ensuring supply chain consistency.
How does Reverse Factoring work?
Reverse factoring is powered by fintech solutions allowing invoice uploads, wire transfers, and invoice payments between the parties involved. The buyer side applies to the financial institution to initiate reverse factoring. The supplier then agrees to the payment terms and discount rate.
Let’s look at how it works.
Reverse Factoring Process
- The buyer places an order for goods or services.
- The supplier delivers the goods or services on credit and issues an invoice.
- The buyer approves the invoice, and the supplier sends it to the financial institution.
- The financial institution sends funds for the approved invoices at a discounted rate.
- The buyer pays the financial institution on the invoice due date.
What are the benefits of Reverse Factoring?
Reverse factoring involves three parties: the supplier, the buyer, and the financial institution. Let’s look at the reverse factoring benefits of each one.
Supplier Benefits
Suppliers benefit from reverse factoring because it gives them early access to working capital. Most suppliers are smaller companies that feed the supply chain for larger companies and corporations.
As a smaller business, suppliers are unlikely to qualify for business financing or only get high rates. With reverse factoring, the financing company bases credit decisions and the interest rate on the buyer’s credit. This allows suppliers to secure less expensive financing for which they wouldn’t normally qualify.
Supplier businesses are often still growing and have high capital expenditures. Interruptions to cash flow from delayed payments can halt a business in its tracks.
Reverse factoring creates consistent early payments on invoices for smooth operations and money on hand to cover day-to-day expenses. It also strengthens the relationship with the buyer.
Benefits for the Buyer
The buyer gets longer to pay the invoice helping with cash flow management. Providing funding to suppliers helps ensure they have the cash to meet deadlines and keep the supply chain moving.
Reverse factoring also helps strengthen the relationship with the supplier. In addition, many suppliers offer early payment discounts. Reverse factoring allows buyers to take advantage of early payment discounts while still waiting to pay until invoice maturity.
Benefits for Financial Institutions
Reverse factoring provides a steady revenue stream for financial institutions, whether it’s a factoring company, bank, or other alternative lenders.
What are the drawbacks of Reverse Factoring?
While reverse factoring programs provide numerous benefits, there are some downsides. For the supplier, the most obvious downside is the discounted rate. Suppliers must decide if the early payment justifies accepting less money than what’s owed.
The buyer initiates reverse factoring, and the supplier decides to accept or not accept. The drawback for the supplier is that it can’t initiate the financing agreement. The buyer faces the possibility that the supplier rejects the agreement in favor of other arrangements, such as factoring their receivables.
Most factoring companies, banks, or other institutions only agree to reverse factoring when the buyer and supplier have a long-standing relationship. In addition, reverse factoring contracts often go on for a long time, making it a significant commitment for all parties.
Reverse factoring is a lesser-known financing strategy that depends on fintech solutions. As such, companies have limited choices of lenders that provide reverse factoring arrangements.
Different states, and countries, have regulatory guidelines that hinder reverse factoring. Ensure you look into the financing laws governing your state or country.
Reverse Factoring Pros & Cons
Pros:
- Provides early payments & working capital to suppliers.
- Provides suppliers with lower-cost funding.
- Suppliers leverage the buyer’s credit for approval.
- It gives buyers more time to pay their invoices.
- Helps strengthen the buyer-supplier business relationship.
- It helps ensure the supply chain moves smoothly.
Cons:
- Discount rates eat into the suppliers’ profit.
- Reverse factoring agreements are long contracts.
- Suppliers & buyers need to have a long-standing relationship.
- Suppliers might reject factoring for their own funding arrangement.
- Dependent on fintech and a lesser-known financing program.
- Potentially limited by state and country regulations.
Frequently Asked Questions
Here are some of the most common questions about reverse factoring.
What’s the difference between Factoring & Reverse Factoring?
Invoice factoring allows businesses to sell their accounts receivable directly to a factoring company, or Factor, in exchange for a cash advance. The Factor then owns the invoice and collects payment from the buyer.
In the Reverse process, the buyer initiates the factoring agreement and works directly with the Factor. The buyer still pays the factoring company in a reverse factoring program.
Is Reverse Factoring the same as Dynamic Discounting?
There are similarities between the two, but reverse factoring and dynamic discounting are separate programs. In reverse factoring, a third-party financing company provides the funding for the early payment to the supplier. In dynamic discounting, the purchasing company deploys its own capital to fund the early payment.
Dynamic discounting still provides suppliers with working capital to keep the business running. The buyer benefits from the discounted sales price and avoids supply chain interruptions but has to provide the money upfront.
Which industries use Reverse Factoring?
Reverse factoring is available for most business-to-business (B2B) companies that purchase on credit. The industries that use reverse factoring most often are:
- Automotive.
- Aerospace.
- Clothing.
- Electronics.
- Manufacturing.
How common is Reverse Factoring?
Despite its numerous benefits, reverse factoring remains uncommon and one of the lesser-known financing methods. It’s estimated that reverse factoring only accounts for 3% of the factoring market.
Reverse factoring began in the automotive industry during the 1908s. Car makers wanted a way to help sure up supply chains by providing suppliers with capital to keep their businesses running.
It made its way into the retail industry since payment delays are common in the sector. Reverse factoring remained a niche for those industries until fintech capabilities and platforms grew significantly in the last decade.
The most significant area for growth in reverse factoring is in the global marketplace. Globalization and offshore production resulted in an expansion of the supply chain. Many businesses experienced a reduction in available capital as a result.
The shifts in the global supply chain created a need for Global Supply Chain Finance (GSCF). While reverse factoring helps provide working capital for businesses in the global supply chain, the laws impacting different countries make it difficult to implement.
However, industry benchmarks indicate that GSCF programs will likely grow to meet a rising need. Reverse factoring may continue to grow along with the need for supply chain finance solutions.
Can I apply for Reverse Factoring?
The purchasing company, or buyer, initiates reverse factoring. Suppliers cannot apply for reverse factoring but can choose to accept or decline it when a buyer initiates.
Buyers are usually large companies and corporations that purchase from various suppliers, which are typically small or medium-sized businesses (SMBs).
SMBs rarely have the credit and negotiating power of larger purchasing companies. Reverse factoring allows SMBs to leverage the credit of the larger company for rates it normally wouldn’t get.
If you are a small business owner looking to factor your receivables, you can still apply for regular invoice factoring. Invoice factoring is the default factoring service and gives you the power to turn unpaid invoices into working capital.
What are my other financing options?
Factoring is a form of working capital financing. If neither invoice factoring nor reverse factoring works for your business, there are several loan options to secure working capital.
Working Capital Loans
There are several forms of working capital loans that provide cash to cover business expenses. Various short-term and long-term working capital loans help your business meet expenses and stabilize cash flow.
Merchant Cash Advance
A merchant cash advance provides an influx of working capital based on a company’s average credit card sales. The business then repays the advance with a percentage of future credit or debit card sales.
Business Lines of Credit
A business line of credit provides a business with funding as needed. It’s like a credit card where the company gets a set credit limit and can draw funds to cover cash flow needs. And speaking of business credit cards, you can also look into the Brex Corporate Card to help with business expenses.
Revenue-Based Loan
Revenue-based financing provides businesses with working capital and flexible payment terms. The company’s revenue determines the loan amount. The company then repays the loan with a percentage of future revenue. It’s excellent for businesses with inconsistent revenue streams since the payment fluctuates with revenue.
Other Small Business Loans
Businesses looking for long-term loans with higher borrowing amounts can look into the following:
Reverse Factoring – Final Thoughts
Reverse factoring offers benefits to both suppliers and buyers in the supply chain. However, its biggest drawback is that suppliers, usually small businesses, can’t apply for it. The buyer initiates the factoring process, which is why it is the reverse of standard invoice factoring.
When implemented successfully, reverse factoring helps secure the supply chain and keep all parties’ businesses moving. It’s one of several forms of supply chain finance, although sometimes the term is used interchangeably with reverse factoring.
Globalization has created a growing need for supply chain financing. Expect reverse factoring and other supply chain finance programs to grow in the coming years.
Whether you’re a buyer interested in reverse factoring or a supplier interested in accounts receivable factoring, contact us to discuss your options. One of our loan experts will discuss your business needs and the right financing program for your goals.
