Most business people are familiar with sales invoice factoring. This type of accounts receivable financing is widely used in many business-to-business (B2B) sectors. However, fewer people are aware of a similar financial product known as reverse factoring or supply chain financing. Here is an explanation of reverse factoring and the benefits of this funding method.
What Is Reverse Factoring?
Reverse factoring is a method of financing purchases that benefits the purchaser and the supplier. The process involves the buyer, sellers, and the factor. But, unlike sales invoice factoring, the buyer initiates a reverse factoring arrangement.
Reverse factoring works similarly to regular factoring, but in reverse, hence the name of the service. The buyer places an order, receives the seller's sale invoice, and sends the invoice to the factor. When the buyer approves the sales invoice, the factoring company pays the seller up to 100% of the invoice value. The buyer later settles the invoice, plus interest and charges, with the factoring company. The immediate benefits are that the seller receives faster or immediate invoice payment, and the buyer usually benefits from extended credit.
The Crucial Difference Between Reverse and Receivables Factoring
The security a funder has with both financing methods is the same; the sales invoice. In both cases, the factor is buying the sales invoice. However, in reverse factoring, the funder funds the buyer rather than the seller. Consequently, the finance agreement is made with the purchaser, and the advance becomes the purchaser's off-balance sheet liability.
Benefits for the Seller
Even though the buyer initiates reverse factoring, the seller obtains significant benefits from the arrangement:
Lower Cost of Financing
The supplier can usually receive an early settlement of the sales invoice from the factor. The invoice will be settled for a discounted amount if the supplier takes this option. But the early settlement cost is likely to be less than the cost of other types of financing.
Based on Creditworthiness of Buyer
A reverse factoring agreement is based on the creditworthiness of the buyer rather than the seller. Consequently, a seller dealing with a buyer with a high credit rating will benefit from financing they may not have otherwise obtained at favorable rates.
Increased Working Capital
The seller will receive cash from the sale invoice faster, freeing up more working capital. That increase in working capital can be used to fund reinvested in business growth, used to gain savings on purchases, or reinvested in product development.
Funding for Significant Orders
A business might have the product or know-how to deliver a significant order but lack the working capital to fund it. In that case, reverse factoring would provide the financing to fulfill such a large order. Fulfilling the order would prove the company's ability to deliver orders of such magnitude, possibly opening up new markets.
Off-Balance-Sheet Financing
The factoring company buys the sales invoice from the seller rather than grant a loan, so the transaction is not recorded as a liability in the seller's balance sheet. Consequently, the seller obtains financing at favorable rates without impacting their credit rating. Indeed, the increased working capital will likely improve the seller's credit rating.
Improved Cash Flow Forecasting
When a reverse factoring agreement is reached with a repeat customer, the benefits to the seller will be ongoing. These benefits will include increased working capital and more predictable cash flow forecasting.
Benefits for the Buyer
The benefits of reverse factoring are far from one-sided. The buyer wins with these arrangements, too, in the following ways:
Increased Working Capital
The buyer will generally pay the sales invoice later with a reverse factoring arrangement in place. This extended credit will increase the buyer's payable outstanding ratio, improving cash flow and working capital.
Reduced Supply Chain Risk
When suppliers have access to the cash for a sales order faster, they will be less likely to encounter challenges in meeting that order. So, reverse factoring helps minimize disruption to the buyer's supply chain. Reverse factoring also creates a better buyer-vendor relationship, often leading to preferential treatment for companies that utilize the service.
Improved Negotiating Position
A sales order, backed by reverse factoring, represents far less risk to the seller. The lower risk puts the buyer in a far better position to negotiate on price and other terms. Indeed, an order backed with a reverse factoring arrangement will be almost as attractive to a seller as a cash-with-order sale.
Removes the Competitive Nature of the Relationship
Negotiations between supplier and purchaser can be highly competitive. The buyer wants the lowest price and extended payment terms. The seller, of course, wants the opposite. With a reverse factoring arrangement in place, the pressure on cash flow is removed from both parties. Consequently, negotiations can be less combative and more focused on reaching a mutually beneficial agreement.
Conclusion
In summary, reverse factoring is an invoice financing agreement instigated by the buyer that benefits both buyer and seller. Also known as supply chain financing, reverse factoring can increase both parties' working capital. And it decreases supply chain risk for the buyer and improves cash flow predictability for the seller. However, reverse factoring is generally only offered to critical suppliers from which the buyer makes significant purchases.
