Reverse factoring is a financial service used to expedite payments to suppliers. Rather than having to wait for an invoice to mature to secure payment for the supply of goods and services, a company may enter into a reverse factoring program whereby they are able to receive an early payment by a factoring firm. The benefits of this arrangement are obvious: trusted suppliers can better deal with cash flow issues and reduce disruption to supply chains. Moreover, reverse factoring creates goodwill and thus improves relations between the buyer and the seller.
Reverse factoring is sometimes referred to as supply chain finance. It differs from invoice factoring in terms of which party initiates the process to make an early payment. With invoice factoring it is the seller that seeks to gain early payment. In contrast, with reverse factoring it is the buyer that applies to a factoring firm to secure early payment for a financial transaction.
Factoring is widely used in supply chain finance. In a business-to-business transaction there is the date that an invoice is issued and there is the date that the invoice is due for payment. The gap between these two dates can create financial difficulties for the seller waiting for payment. If an invoice gives a buyer 30 days to pay for goods and services, they will invariably wait for 29 days before transferring funds. When large sums of money are involved, the delay can cause cash flow issues, and may act as a deterrent to making such deals.
Since it is the buyer that enters into a reverse factoring agreement with a factoring firm, it is only the buyer’s credit rating that affects the deal terms. A large buyer, with solid financials, will typically be able to secure a lower fee for a reverse factoring service than a smaller seller or supplier.
The Process of Reverse Factoring
There are a number of steps in the reverse factoring process:
- A buyer purchases goods or services from a supplier.
- The supplier sends the invoice to the firm offering reverse factoring along with information about the terms of payment such as the due date for payment.
- The buyer approves the validity of the invoice to the factoring firm.
- The supplier can then request an early payment for the invoice from the factoring firm.
- The supplier then receives early payment for most (up to 90%) of the amount indicated on the invoice.
- The buyer sends the full payment to the factoring firm on the maturity date of the invoice, and the factoring firm takes its initial payment and its fee and remits the remaining sum to the supplier.
It should be noted that as with invoice factoring there are fees involved in this process. A factoring company does not release all of the funds at once. They assess risk and other factors and pay a percentage of the total invoice.
Why is Reverse Factoring Important?
There are several benefits to both the buyer and seller in using reverse factoring.
For the supplier cheaper credit is available since it is the buyer’s credit rating that is assessed. Days Sales Outstanding (DSO) is reduced and thus working capital is strengthened. Suppliers can utilize early payments for research and development for their business. Alternatively, the early payment can be used to fund expansion. And lastly, suppliers have better control of their cash flow. Certainty of payments and their timing make it easier for suppliers to make business plans.
For the buyer there are also a number of benefits. If a supplier knows they will be paid early by a reverse factoring program they will be more willing to issue invoices with longer maturity dates. This improves the Days Payable Outstanding (DPO) for the buyer. A very important benefit for the buyer is that reverse factoring reduces the risk of supply chain disruption – since the seller has access to early payment it makes it easier to meet deadlines for delivery of goods or services. With no blockages in supply or payment, buyers and sellers strengthen their business relationship. Buyers offering reverse factoring as a means of payment may also be able to secure discounts on purchases.
Thus, reverse factoring is clearly beneficial to both the buyer and seller. Advances in technology have reduced the costs of offering reverse factoring, making it a more attractive proposition to large companies with hundreds of suppliers. Digital platforms for reverse factoring make it easier to onboard suppliers and deal with administration. For these reasons businesses see the fees paid to factoring companies as money well spent.