Reverse factoring is at its simplest, where a supplier receives finance in relation to their receivables (money for goods/services delivered) by a process that is started by the ordering company. It allows the supplying company to receive better finance terms than it would otherwise be able to receive from a lender.
Reverse factoring explained
Before going into the depths of reverse factoring, it is first important to know the difference between invoice discounting and factoring.
Factoring is the true sale of receivables and invoice discounting is when a company is able to sell their unpaid invoices to a financial institution and receive a loan, with the accounts receivable being used as collateral. The client will sell the unpaid invoices to a financier who will sometimes retain control of the debt-collection process, in return for fees and/or a proportion of the value outstanding.
Reverse factoring would allow suppliers to be paid in a timely manner for a fee that is taken care of between large retailers and banks. By entering into this supply chain finance mechanism, it means that when the buyer has approved the invoice sent from the seller; which is an account payable (AP), the funder will provide the seller (where requested) with finance that is advanced against the AP. The buyer then pays the funder at the agreed time on the invoice sent.
The need for this system in some cycles is due to long delays of large companies to pay suppliers. Large companies (such as retailers) will agree to pay a bank the money which is owed to creditors within the trade and banks would then pay suppliers the money that is owed to them immediately; this is rather than waiting the 30-90 days which is required by the large retailers.
Suppliers have a difficult relationship with many corporates as these buyers dictate their payment terms. Suppliers also do not want to wait a long time to be funded as they are usually growing businesses with high capital expenditure costs. Conversely, suppliers understand the huge opportunity that is presented to them when faced with a purchase contract from one of these large entities.
Reverse factoring started in the car industry, as it allowed car companies to work more efficiently with their smaller supply companies. It also assists in industries where payment delays are the main fear or roadblock to the business.
The market size of reverse factoring is relatively small (around 3%) as a proportion of the entire factoring market. Aite Group has estimated that the market size for reverse factoring was between US$255-280 billion in 2015.
The benefit of a reverse factoring facility is that it is usually a simple system set up and there are lower costs involved to the supplier. The reason is due to the funder taking credit risk on the large corporate compared to the small supplier. The financier behind a scheme may also charge the supplier a couple of percent of their funding line, to join the reverse factoring scheme.
The availability of reverse factoring means that it could provide a line of finance to companies that was previously inaccessible. Growing suppliers are able to receive funding quicker, so assisting with their growth and avoiding any potential insolvency situation. It also important to note that reverse factoring would be more inexpensive than traditional factoring arrangements.
Reverse factoring will work where a funder sits between a company and its suppliers; where there is a commitment to fund the company’s invoices from suppliers at a faster rate than provided by a company; in substitution for a discount.
Traditional factoring works on the basis that a business receives finance on their receivables. Conversely, reverse factoring (or supply chain financing) is a solution where the buyer assists his suppliers by financing their receivables using a more flexible method and at a lower interest rate than would be offered. As a proportion of the market; reverse factoring is less than 5% of the factoring market.
This is a very beneficial relationship as everyone in the chain understands the necessity of the funder and as the buyer is assisting the supplier it can hopefully mean a longer term and more beneficial long-term relationship.
Types of reverse factoring include:
- Cash flow from the business or lending
- Invoice finance
- Invoice discounting
- Import factoring
- Structured finance
Companies looking for reverse factoring are generally seen on a case by case basis. Normally, a financier would ask for the following in an application:
- Audited financial statements
- Full business plans
- Financial forecasts
- Credit reports
- Details and references of the directors
- Information on assets and liabilities
The liability of the funder is concentrated on a large credit worthy company
It means that a funder does not have to worry about fraudulent invoices
There is clarity for all parties on knowing when payment will be received; so no long or unnecessary delays
It limits any disputes as both sides have agreed the invoice
Reduces supplier cash flow demands and management of invoices
It is a validated regime, so as soon as both parties have agreed to an invoice – the supplier is protected in a later non-payment event
A funder only has one party to collect payment from – which is usually a large corporate
Close relationships are created between buyers and groups of suppliers; allowing new companies to work with large corporates
There is less administration and chasing for payment
The agreed rate in relation to the whole invoice is advanced, compared to in a standard discounting scenario where there is a percentage advance rate with the collecting of a further sum on payment
Liability and risk is assumed by the (usually) larger buying company, so the rate of interest is lower