Reverse Factoring

Reverse Factoring refers to a concept when a firm reaches out to a financial institution to pay its suppliers at a faster rate in exchange for a discount, thereby reducing the account receivables time for the suppliers without any credit crunch for the firm, which in turn will be paying out to the lender at the end of predefined time duration.

Reverse factoring is a part of Supply chain finance aimed at removing the frictions in the ecosystem and leading to a better flow of cash faster and more efficiently by focussing on one of the major touch points between the suppliers and firms – accounts payable. Unlike factoring, it is initiated by the firm rather than the suppliers to finance their account receivables. If implemented correctly, it can help improve liquidity in the system, better cash circulation, timely payments, fewer defaults, and eventually better profit-generating capabilities for the firm and its suppliers.

The concept of reverse factoring involves three parties, the buyer, the factor or financial institution and the supplier. The process involves a collaboration or agreement, where the buyer approaches an institution with the amount that they need to pay the supplier and enters into a contract where the factor will pay the supplier an amount equal to the purchased amount immediately and later on the buyer will settle it with the factor.

In a reverse factoring agreement, the buyers are usually large companies who need to handle many supplies at the same time. This arrangement facilitates payment handling because the suppliers get the payment before the due date, which helps them to maintain a healthy cash flow and at the same time, a good relationship with the buyer. They receive funds early without much of a waiting period, which would otherwise have kept their funds blocked.

The factor charges an amount against earlier payment to supplier, whose rate is usually lower than the normal market interest rate. This is also useful for the supplier since it helps them to avoid huge interest payment as in case of normal loans.  

Overall, it is a great option from the supplier’s point of view since it is a process of maintaining financial stability, helps the reverse factoring companies earn interest on early payment and helps buyer of goods by postponing payables for a certain period and use the funds for other productive purpose.

Let us understand the concept of reverse factoring agreement with the help of a suitable example as given below.

Consider a scenario where a firm wants raw material to fulfill an order in another two months. The raw materials required are worth $ 2 million, and the firm does not have any money. Also, as per the contract terms, it does not expect any cash inflow for another two months. Let’s consider the options the firm has in such scenarios.

1. The firm reaches out to its suppliers and asks for raw materials on credit. It promises them that the invoice will be paid out as soon as it receives cash from its clients. However, that would require at least two months. Here the supplier might say No or yes, but in both cases, the firm is taking a risk, which eventually puts constraints on its cash flow and balance sheet.
2. The second scenario is when the firm reaches out to a lender/bank and works with them to pay out their suppliers. The whole machine consists of the following steps:
   • The firm initiates an order for the raw materials with its supplier.
   • The supplier reviews the order, provides the raw material to the firm and builds an invoice for the required payment – $ 2 million.
   • Firm reviews and confirms the payment, confirming to the lender that it will pay the required amount at maturity at the end of 2 months.
   • The supplier then sells these invoice contracts to the lender at an agreed discount (5%).
   • The supplier receives the account receivables in real-time and must not wait for two months.
   • At maturity, the firm (buyer) makes the payment to the lender/financial institution.

Please note that since the firm has arranged the lender, the payment will be paid out to the supplier, and the discount will be based on the creditworthiness of the firm.

Below are the advantages of reverse factoring process.

• Invoices are paid to suppliers much faster, avoiding delays in receiving account receivables. It leads to improved cash flow in the system, which can generate more profitability.
• Since invoices are paid on time, suppliers do not need to chase the firms for early requests. Both parties can focus on their core activities rather than payment schedules or delays. Undoubtedly, this will lead to better management and better utilization of resources.
• The concept of reverse factoring is an agreement between the bank and the firm and not between the suppliers. The terms and interest rates are aligned with the firm's creditworthiness without impacting the suppliers.
• Reverse factoring is an off-balance sheet mechanism. In turn, the balance sheet looks good by having better ratios like working capital turnover, and trade payable turnover for the firm to keep both investors and shareholders happy.

The following are a few disadvantages of Reverse Factoring.

• The agreement of reverse factoring depends a lot on forecasting the sales and the anticipation that the buyer/firm would be able to make a trade and return the invoice amount to the bank with a prespecified interest rate after a certain period. If this does not happen, then banks will be at a loss, and due to the regulatory scrutiny might take away the collateral leading to a credit crunch situation for the firm. This scenario can lead to a much worse condition as the funds for the firm may dry up when it needs the most.
• If not arranged properly, it can be very expensive for the firm as it may require complicated contracts and ambiguous rules.

• Reverse factoring is a supply chain optimization mechanism that helps in better collaboration between the participants. Because of the timely payments, reverse factoring process helps in resolving any disputes and develops better relationships between the firm and its suppliers.
• The eventual goal of reverse factoring is to reduce the time for account receivables and improve cash flow. A cost-effective mechanism reduces any constraint on the firm and its suppliers.
• Reverse factoring has already disrupted the industry. Although it started with the automobile industry, it has done wonders in many capital-intensive industries like aerospace, pharma, telecom, consumer packaged foods, chemicals, etc. Many fintech firms are trying to explore this avenue of reverse factoring trade finance further. In their independent research, many consulting firms have estimated the reverse factoring market to be around the US $ 255 -285 billion ( 2015 estimate). However, the great part of this research is that size is currently at 3% and has the potential to reach 20-25% of the industry's accounts payable in the near term.
• Reverse factoring only makes sense if the rate of interest or discount offered by the intermediary financial institution is low and based on the credit rating of the firm rather than the supplier. It is just a delayed overhead.
• Reverse factory benefits can be quantified based on the models that study the ecosystem by optimizing the accounts payable. The results suggest that the supplier captures 25 – 45% of the value, and the buyer captures 35-45%, while the financial institution captures the remaining 15-20 %.

The above are two different financial techniques that any business can use in order to manage the cash outflow and inflow in a systematic manner so as to meet deadlines without creating any cash crunch. However, there are some differences between them as follows:

• The former is usually a process that is followed by large corporates and the latter is usually a process that small business follow.
• In the former, the financial institutions or reverse factoring companies help companies and businesses get funds at lower rates and pay the suppliers on time, without delay. But in case of the latter, the business sells the receivables to a financial institution at a discount, to obtain fund.
• In case of the former, the advance payment is made to buyer but in case of the latter, the advance payment is made to the seller of goods and services.
• In case of the former the buyer initiates the agreement whereas in case of the latter, the seller initiates the agreement.
• From the above point we can assume that the risk is borne by the buyer in case of the former because later on if the financial condition of the buyer deteriorates, it will be difficult for them to pay the financial institution the factoring amount but in case of the latter the seller bears the risk, which means if the buyer is unable to pay the factor, the seller suffers.
• The main purpose of the former is to leverage buyer’s creditworthiness and obtain funds from the factor or financial institutions and the main purpose of the latter is to leverage the value of the accounts receivable and obtain funds to meet business needs at low interest rate.
• In simple words, the reverse factoring trade finance is using the accounts payable to meet financial obligations on time and the latter is using accounts receivable to obtain funds in the form of loan to meet business requirements.

Thus, the above are some important differences between them.

This has been a guide to Reverse Factoring & its definition. We explain the differences with factoring, along with examples, disadvantages & advantages. You may learn more about our articles below on Finance –

• Recourse Factoring
• Accounts Receivables Factoring
• What is Unsecured Loans?
• WIP Inventory