Last Updated on September 21, 2021
According to a JP Morgan Index Report, the amount of working capital trapped in supply chains rose to 8% last year. We don’t know what this year holds, but you can prevent your company from being part of such stats through Fintech options like reverse factoring.
You may have have heard of invoice factoring, or accounts receivable financing, which is the process of a factoring company purchasing your outstanding invoices in exchange for cash. However, if you’ve never heard of reverse factoring, you’ve come to the right place. This article will explore what reverse factoring is, its benefits, drawbacks, and how it compares to other forms of factoring.
What is Reverse Factoring?
Commonly referred to as supply chain financing, reverse factoring is a buyer-led Fintech solution in which a financial institution finances invoices for suppliers at discounted rates and offers the short-term buyer credit against the invoice.
At its simplest, a successful reverse factoring process means the supplier gets paid for their receivables immediately, and the buyer gets more time to clear the invoice.
How Reverse Factoring Works
The reverse factoring process is buyer-led. That means the ordering company usually initiates it. Here is an overview of how it works:
- The buyer puts in an order with the supplier
- The supplier fulfills it and forwards the invoice to the buyer
- The buyer approves it and requests a financial institution to serve as an intermediary by paying out the invoice at a discounted rate
- If the bank agrees, the supplier receives payment for receivables immediately
- The buyer clears the invoice amount to the financial institution at maturity
The Benefits of Reverse Factoring
Reverse factoring is typically a three-party transaction in which everyone benefits. Here’s what buyers, sellers, and the financial institution stand to gain:
Benefits for the Buyer
There are tons of buyer benefits to reverse factoring. Here are a few examples:
Longer Payment Terms
Buyers using reverse factoring can increase the payment duration without necessarily negotiating other factors such as price.
Improved Cash Flow
Since the buyer doesn’t have to pay immediately, no working capital is trapped in their supply chain. This process significantly improves their cash flow and facilitates smooth-sailing business operations.
Better Buyer-Supplier Relationships
Reverse factoring enables the buyer to ensure supplier invoices are paid on time. That significantly improves their relationship with the supplier and may even unlock preferential invoice rates for them in the future.
A Stronger Balance Sheet
Reverse factoring is an off-balance sheet Fintech option. That means, if approved, the resulting balance sheet shows improved days payable outstanding ratios, better working capital turnover rates, and enhanced trade payables turnover ratios. It is beneficial for small businesses because a stronger balance sheet portrays better financial health, making other suppliers, potential investors, and lenders more willing to work with you.
Cash Discount Benefits
Most suppliers often offer superb discounts to buyers who clear out invoices immediately after fulfilling the order. Through reverse factoring, suppliers receive an immediate cash-injection, allowing the buyer to maximize the cash discounts.
Benefits for the Supplier
Similar to the buyer benefits, the benefits of reverse factoring for suppliers run a wide gamut, including:
Improved Cash Flow
Reverse factoring turns invoices into fresh money immediately. No more waiting for 30 to 45 days for payment. That helps improve cash flow for their businesses.
Improved cash flow means more working capital for suppliers. More working capital means they can maximize any suitable growth opportunities that land their way.
Unlocks Access to Better Interest Rates
When a supplier works with buyers who use reverse factoring, they receive payment on time each time. That creates a record of undisputed sales and improves their balance sheet, giving them the upper hand while negotiating interest rates with potential lenders.
Improved Financial Security
Supply chains are unpredictable. There’s no telling when things will go wrong. While suppliers can do nothing about the uncertainty, reverse factoring means they get paid faster and efficiently. As a result, they build robust cash reserves, making them better armed at dealing with any financial crisis that may arise in the future.
Efficient Cash Forecasting
Through reverse factoring, suppliers have greater control over the timing of future payments. They know when they fulfill an order, they’ll get account receivables within 5-10 days. That allows cash flow forecasting, which in turn enables them to plan better for future investment opportunities, anticipate and resolve cash shortages before they occur, and track their spending.
Benefits for the Financial Institution
Banks and financial institutions with reverse factoring programs enjoy the following benefits:
- Long-term cash flow through the interest payments made by the buyer in current and future reverse factoring transactions
- Reverse factoring programs make banks and other financial institutions appealing to reputable buyer and supplier corporations looking to prevent supply-chain related cash flow problems
Drawbacks of Reverse Factoring
Although beneficial, reverse factoring comes with some definite disadvantages too. These include:
- Most financial organizations agree to reverse factoring arrangements only if the supplier has a long-term relationship with the buyer.
- The agreements can be pretty lengthy (read more on our what is a factoring agreement article)
- There’s a probability the supplier may reject this arrangement because they prefer setting up their funding arrangements.
- The success of reverse factoring programs for financial institutions can be hindered by the legal and regulatory frameworks of the country in question
Reverse Factoring vs. Other Types of Factoring
Here are the differences between reverse factoring and other types of factoring:
Reverse Factoring vs. Invoice Factoring
Reverse factoring is often confused with invoice factoring, but they’re two entirely different financial arrangements.
In invoice factoring, the supplier sells their invoice(s) to a factor (the bank or financial institution) at a discount. They get the invoiced amount immediately, and the factor is left dealing with the buyer. In reverse factoring, it’s the buyer who initiates the process and not the supplier.
Reverse Factoring vs. Dynamic Discounting
In dynamic discounting, the buyer offers to clear the suppliers’ invoices early in exchange for a discount. The earlier they pay, the bigger their discount. Reverse factoring is different from dynamic discounting in that the buyer finances the supplier’s invoice instead of an intermediary like a bank.
Reverse factoring is an excellent way for both buyers and suppliers to ensure no money is stuck in their supply chains. It benefits everyone involved in the arrangement and is a great way for small businesses to expand their territories.
Jim is the General Manager of altLINE by The Southern Bank. altLINE partners with lenders nationwide to provide invoice factoring and accounts receivable financing to their small and medium-sized business customers. altLINE is a direct bank lender and a division of The Southern Bank Company, a community bank originally founded in 1936.