What is Reverse Factoring in Supply Chain Finance?
Reverse factoring, or supply chain finance, is a fintech method initiated by the customer to help financially support its suppliers by financing their receivables, where a bank pays the supplier’s invoices at an accelerated rate in exchange for lower rates, thus lowering costs and optimizing business for both the supplier and customer.
How Does Reverse Factoring Work?
The reverse factoring process involves an ordering party (a customer) contacting a financial institution, such as a bank. The customer then asks that institution to be an intermediary between itself and its supplier. If the bank says yes, then payment terms are negotiated.
The bank then agrees to pay specific approved invoices that the ordering party owes to the supplier in exchange for a fee. The fee is paid by the supplier. The result is that the supplier can get paid faster and the ordering party has more time to pay the invoices. The ordering party then pays the invoices to the bank at a later date.
There are benefits to all three parties involved in the agreement. However, banks typically only agree to reverse factoring deals when the ordering party is a large entity such as an enterprise venture. Banks see these brands as having better creditworthiness and thus represent a lower credit risk.
It’s challenging to banks to enter into reverse factoring agreements with small businesses. Oftentimes, smaller companies are perceived as being higher risk to financiers. However, that’s not to say it’s impossible.
The Key Advantages of Reverse Factoring for Suppliers
The primary benefit of reverse factoring for suppliers is that they can get paid in 10 days instead of the typical 30-45 day turnaround. This helps to optimize cash flow and gives them access to critically needed working capital.
Reverse factoring also prevents them from having to deal with late payments which can interrupt business. It provides a greater sense of stability and security to suppliers on the supply chain.
Another key benefit for suppliers is that the interest rate that they are charged by the financial institutions is typically lower than it is for other types of financing. That’s because the fees are usually based on the credit rating of the paying company, not the supplier. These credit ratings are good because the paying companies are generally larger corporations.
Benefits for the Ordering Parties
Ordering parties benefit from reverse factoring by not having to deal with requests for early payment. They have more time to collect the money and make the payment to the bank. This also means they don’t have to worry about harming their relationship with a seller over late payments.
Another main benefit for ordering parties is that they can become more desirable for suppliers to work with. That’s because suppliers are more fond of reverse factoring agreements since they get paid faster. So, reverse factoring helps ordering parties to create stronger relationships with suppliers and it takes the pressure off to pay quickly.
Takeaways for Financial Institutions/Factoring Companies
Financial institutions benefit from reverse factoring agreements in many ways. It helps to develop sources of long-term cash flow through interest payments made by suppliers. These revenue streams can be enormously profitable for financial institutions over long periods of time.
Many financial organizations are willing to enter reverse factoring agreements because they believe that the ordering party represents a low risk. However, these companies will usually only agree to these arrangements with suppliers that have had a long-term trading arrangement with the ordering party.
Who is Using Reverse Factoring?
Reverse factoring can be used by companies in any sector as long as the ordering party is low risk. It’s important that the financial institution believes the relationship between the ordering party and the supplier is strong and trustworthy. Reverse factoring is used in industries like:
Despite the fact that reverse factoring is used in many different industries, it is still a relatively rare financing method. It is estimated that reverse factoring could handle about 25% of trade finance. Right now, however, reverse factoring accounts for only about 3% of global trade finance.
What is the Difference Between Traditional Factoring and Reverse Factoring?
There are a number of key differences between these financing strategies, though both are used for similar purposes. One of the biggest differences between factoring and reverse factoring is that factoring is initiated by the supplier and not by the ordering party.
Another important difference between factoring and reverse factoring is that factoring qualifies as debtor finance and reverse factoring does not.
With factoring, suppliers will sell their accounts receivable to a third party, known as a factor, typically at a discount. In this way, the supplier can get paid faster and the factor can make a profit. They do this by collecting the accounts receivable at full price from the ordering party.
Many suppliers use this type of financing because it allows them to resolve immediate cash flow needs. That’s why many are willing to take slightly less money from the sale of their goods because they end up getting paid significantly faster.
In order for the factor to profit from factoring arrangements, it will still have to collect the accounts receivable from the ordering party. So, this can present a risk to the factor.
For this reason, most factors will only enter into deals where they are confident the ordering party will pay. Both factoring and reverse factoring can be used to help companies on a supply chain be paid faster.
The Bottom Line
Reverse funding is a suitable supply chain financing strategy for many situations. It provides benefits to suppliers, ordering parties, and financial institutions alike.
However, despite this fact, it still remains one of the least commonly used financing methods for supply chain companies. This is seemingly because many companies find it easier to just sell their accounts receivable at a discount to a third-party.
For companies that have a need to receive payments within ten days, reverse funding is an excellent option. In the near future, reverse factoring could become significantly more popular due to the many benefits that it provides.
This is especially true if banks become more interested in using the practice to generate revenue streams. But reverse factoring has a long way to go before it can catch up to competing financing methods.