What is Reverse Factoring?
Reverse factoring is a method of financing where the buyer (importer) makes provision for a financing arrangement wherein a supplier (or exporter) can choose to receive an early payment on the invoices it draws against the buyer/importer for a small fee and collects payment from the buyer at a later due date.
The financier in this transaction is called the factor.
Since the buyer approves the financing against accounts payables, it is synonymously referred to as payables financing.
Since it also helps keep the supply chain run smoothly without any hindrance, it is also used synonymously with supply chain financing, however, there is no official definition of supply chain financing and it is a much broader international trade finance term that encompasses several different financing techniques.
Reverse factoring, is a way of factoring in finance that enables large companies to offer early payments to their suppliers based on approved invoices.
Usually, large companies arrange with financiers to provide factoring services to some or all of their suppliers.
Instead of these small suppliers having to arrange their own facilities, the large debtor creates a facility where financiers can draw comfort from the buyer's credit profile and suppliers enjoy lower interest rates.
The suppliers participating in the reverse factoring program can request early payment on invoices from the financiers. The buyer company sends the payment to the financier on the invoice maturity date.
Buyers give suppliers access to reverse factoring and reduce the risk of disruption in their supply chains, thus strengthen their relationships with the suppliers and at the same time improve their own working capital position.
Since the cost of this facility depends on the buyer’s credit rating, it is usually lower than what the supplier could have secured on its own.
We have covered the meaning and workings of supply chain finance in this post separately.
Need for Reverse Factoring
In most trade relationships, the buyer (or importing) company is much larger than the supplier it procures goods from. Usually, the buyers dictate the payment terms in such cases which could be delayed/prolonged.
However, suppliers need immediate access to funds to meet the large orders. Reverse factoring, which is an important technique of import finance becomes very useful under such circumstances as the suppliers get immediate access to money instead of waiting for 30-90 days (usual payment terms of large companies), at a reasonable cost.
Who Uses Reverse Factoring
This is more a question of, when does reverse factoring make sense for the parties involved. In general, reverse factoring is best suitable for larger businesses where the importing company is a fairly large firm that is capable of borrowing funds at competitive prices to ensure that their suppliers are paid on time.
So essentially, all the parties involved in a factoring transaction include:
- The buyer or the importer, also the debtor who needs to make the payment on the due date directly to the factor
- The seller or the exporter, also the creditor in the transaction. Who enjoys early payment at a competitive price
- A factor, who is the financier in the entire transaction. A factor charges a fixed % interest on the outstanding balance from the buyer for all the invoices raised by the suppliers. A factor may choose to make direct payments into the suppliers account or route it through the buyer/importer
Reverse factoring is ideal for companies in any sector as long as the buyer is relatively low risk and the relationship between buyer and seller is strong. Reverse factoring is used in industries like automotive, manufacturing, electronics, retail, engineering and more.
How Does Reverse Factoring Work?
There are a number of steps in the reverse factoring process:-
- A buyer company contacts a financier (or factor) to be an intermediary between itself and supplier.
- The financier agrees to approve invoices that the buyer owes to the supplier against an agreed fee that is paid by the borrower (the importer). This fee includes a convenience fee and a pre-agreed interest rate on the outstanding balance.
- The buyer places order for purchase of goods with the supplier.
- Supplier sends the invoice to the financier on which payment is due on a future date, in some cases the supplier sends this invoice post-shipment or before manufacturing the goods or anytime in between.
- Buyer approves the invoice and an early payment option is made available to the supplier.
- Supplier requests early payment on the invoice from the financier. This facility is discretionary.
- Supplier receives payment after deduction of a small fee.
- Buyer sends payment to the financier on the maturity date.
Requirements & eligibility criteria for reverse factoring
Factors or financiers of the reverse factoring solution typically have baseline eligibility requirements, for instance, the importer should have had x years of track record, $X turnover over the last financial year and a moderate to healthy balance sheet. Some documents that the factor may request are:
- Audited financial statements
- Business plans
- Financial forecasts
- Credit reports
- Details of the directors
- Information on assets and liabilities
Example of Reverse Factoring Transaction
There is a car manufacturing company, XYZ Inc in the United States. This company has long-term relationships with many auto ancillary suppliers including ABC Ltd in Austria, who makes steering wheels. ABC Ltd is a small manufacturer and needs fast access to funds to procure raw material for every order placed. If these payments are delayed, it affects the supply chain to XYZ and consequently XYZ’s supply logistics and sales. XYZ Inc also needs access to working capital for its other needs. So XYZ Inc proposes a reverse factoring arrangement and enters into agreement with DEF Capital.
In the following month, XYZ Inc placed a large order for some steering wheels with ABC Ltd. ABC Ltd then sends an invoice to XYZ for the execution of this order. ABC can now either wait for the usual 45 days to receive the payment or access an early payment from DEF Capital following the reverse factoring agreement that XYZ has set up with the financier.
ABC logs in to an online system, selects the invoice that it needs to be paid early against a small finance fee to DEF Capital. XYZ is happy with this arrangement as the financier has seen XYZ’s healthy credit rating and agreed to double the usual 45-day credit period of XYZ with the suppliers. As a result, XYZ now has 90 days to pay any outstanding invoices, freeing the working capital that can be used in other areas of business.
Benefits of Reverse Factoring
Reverse factoring is useful for both buyers as well as suppliers. It improves cash flow, reduces supply chain risk. It lowers costs and is beneficial for both, the supplier and the buyer due to reduction in longer payment cycles and optimization of working capital cycles.
Benefits to Suppliers
Improved cash-flow: Suppliers get faster payments leading to better cash flow management and improved financial health for the organization.
Reduction in disputes: The presence of a factor means invoices are already agreed upon, and suppliers do not have to worry about non-payment or fraudulent invoices. The factor takes on the risk here. A factoring arrangement where the seller's risk is not absorbed is known as recourse factoring. You can read more the two common types of factoring: recourse and non-recourse factoring here.
Low interest rates: Lower interest rates are charged by the financier as they are based on the creditworthiness of the (usually larger) buyer company, not the rating of the suppliers.
Less administrative work: Businesses using reverse factoring/ factoring arrangements spend less time performing administrative work and can focus on more critical business areas
Benefits to Buyers
Buyers also benefit from reverse factoring. The most important include:
Increased liquidity: Since the suppliers are paid immediately, the buyers don’t have to entertain early payment demands by the suppliers. This can be used to bolster inventory and strengthen domestic operations Strengthening of supplier relationships: The supplier gets access to funds at a preferential rate due to the buyer's credit rating, thus giving a positive image to the buyer and building a strong relationship between buyer and supplier. Reduction of supply chain risk: With suppliers getting easy access to funds, risk of disruption to supply chain is reduced. Better negotiating position: Providing several supply chain finance products as options to the suppliers leads to a better bargaining position to the procurement team to negotiate commercial terms. Business growth: Even small suppliers can invest in their growth and help the buyer grow its business.
Drawbacks of Reverse Factoring
The biggest disadvantage of reverse factoring is that the supplier has to work with the factor selected by the buyer, and under the terms negotiated between the buyer and factor. The supplier cannot influence the selection or terms of this financial arrangement.
It is typically reserved for medium-larger businesses and doesn’t make a lot of sense for micro or small businesses.
It can also be a slightly complicated financing model to understand and thus, importers may shy away from reverse factoring, in general.
Alternatives to Reverse Factoring
This novel trade finance technique may not be preferred by many inmporters in the United States due to a lack of awareness, the slight level of complexity in a reverse factoring program and also simply because small sized importers don't benefit from the program.
To resolve this, here are the alternatives to a reverse factoring arrangement.
Letter of Credit: A letter of credit document helps importers draw comfort from the execution risk of the suppliers. The exporter can also avail financing against LCs in order to placate their cash flow problems
Purchase Order Financing: A purchase order financing is a solution where an importer simply approaches a financing institution and requests early payment against the purchase order. This guide on purchase order financing covers its working in detail.
Difference between Reverse Factoring and Invoice Factoring?
Reverse factoring vs. Dynamic Discounting
FAQs on Reverse Factoring
What are the accounting implications of supply chain/reverse factoring? Supply chain finance does not count as additional debt for the buyer or supplier. For buyers, trade payables stay as trade payables. For suppliers, there is no effect on outstanding debt or balance sheets.
Is it mandatory to use reverse factoring for every invoice? No, the use is discretionary. This financial instrument can be used when the supplier needs early access to the funds.