When you need extra working capital to keep your cash flow strong, there are plenty of financing options out there that will give you the funds you need. Reverse factoring is notorious as one of the most complicated forms of supply chain finance, but with a clear explanation, even the greatest mysteries become simple to understand. In this guide, we’ll break down everything that a small business or a large company needs to understand this common solution to cash flow problems.
What Is Reverse Factoring?
Reverse factoring is a type of invoice finance that suppliers and buyers use to keep the ball rolling without making payment in full at the time of purchase. Unlike traditional factoring, buyers initiate reverse factoring. In traditional invoice factoring agreements, the supplier initiates this type of financing solution.
The driving reason buyers pursue reverse factoring is cash flow issues. When a buyer doesn’t have sufficient working capital to make a purchase from a supplier, he or she may contact a factoring company to arrange this type of trade finance.
When a reverse factoring agreement is successful, each party benefits. The buyer can receive the supplies he or she needs without having to pay the full amount, the supplier receives the cost of the invoice without having to wait, and the factoring company profits from interest and administrative fees.
Reverse factoring may even be preferable to suppliers since they can often receive reduced interest rates when they pursue this type of invoice finance. We’ll explain all the details as we continue.
What Is the Difference Between Reverse Factoring and Factoring?
Traditional invoice factoring is essentially a simpler form of reverse factoring. In traditional factoring arrangements, a supplier agrees to sell its accounts receivable to a bank in exchange for a portion of the invoice amount up front. While the buyer needs to be involved in this finance process to a minimal degree, traditional factoring is not buyer-originated.
Instead, the buyer simply needs to work with the bank to make payment on the factored invoice. Instead of paying the supplier directly, the buyer pays the bank for the invoice amount at the predetermined date. The bank takes full responsibility for credit control on the invoice, and it will pursue any delinquent payments or bad debt.
There’s a significant difference between traditional factoring and reverse factoring on the supplier’s end. Since banks consider reverse factoring to be less risky, they are willing to offer better interest rates. Therefore, the supplier can keep more of the money it made on the sale once the invoice reaches maturity and the buyer pays the full invoice amount.
Banks consider this type of invoice finance to have less credit risk since the buyer initiates it. Since the buyer takes on all the risk of a reverse factoring agreement, the supplier can often receive the full amount of the invoice value up front.
This aspect of reverse factoring is in stark contrast to the terms of traditional factoring. Since a bank takes on a considerable degree of risk in a traditional factoring agreement, it usually can’t provide more than 80-85% of the invoice value up front.
Invoice Discounting vs. Invoice Factoring
Invoice discounting and reverse factoring are on opposite ends of the spectrum when it comes to buyer involvement. When a supplier makes an invoice discounting agreement with a bank, the buyer usually has no involvement in the finance process. Instead, an invoice discounting agreement only involves the supplier and the bank.
In an invoice discounting agreement, a supplier agrees to sell its invoices to a bank in exchange for around 90% of the invoice value. The supplier retains control over the invoices for credit control purposes. Since the buyer isn’t involved in the invoice discounting process at all, this type of finance agreement is also called confidential invoice discounting.
Reverse factoring, on the other hand, requires the intimate involvement of the buyer, supplier, and bank. The buyer receives financing to make the purchase, the supplier sells the invoice to the bank, and the bank takes responsibility for credit control on the invoice. There’s nothing confidential about reverse factoring, and this type of supply chain financing only works when all concerned parties work together fluidly.
How Does Reverse Factoring Work?
Reverse factoring is an understandably confusing topic. To help explain how this type of finance agreement works, we’ll break down the entire process step-by-step:
- The buyer places an order: Just like usual, the buyer places an order with the supplier. However, the buyer has already made a reverse factoring agreement with his or her bank ahead of time.
- The supplier invoices the buyer: Upon receiving the order, the supplier invoices the buyer. The supplier then logs this invoice in its balance sheet.
- The buyer confirms its intent to pay the bank: Upon receiving the invoice, the buyer contacts his or her bank and confirms that the invoice will be paid in full at the designated maturation date.
- The supplier sells the invoice to the bank: After receiving notification from the buyer and the bank, the supplier sells the invoice to the bank. This financial institution then takes on all credit control responsibility for the invoice.
- The supplier receives an advance on the invoice value: After selling the invoice, the supplier receives the agreed-upon value of the invoice from the bank. Unlike traditional invoice factoring, the reverse factoring agreement allows the supplier to receive the full invoice value upfront.
- The buyer pays the full invoice amount: On or before the specified invoice maturation date, the buyer pays the full value of the invoice to the bank. If any amount of the invoice value was withheld from the supplier, it is paid at this point.
Benefits of Reverse Factoring for Buyers, Suppliers, and Banks
Reverse factoring is commonly considered to be a win-win situation for everyone involved. As long as the buyer pays the invoice value by the due date, this type of short-term loan can be beneficial for the buyer, the supplier, and the factoring company.
For the buyer, reverse factoring extends the payment terms for his or her order without having to ask the supplier to go out on a limb. While many suppliers are happy to offer net-30 or net-60 terms, others aren’t, and reverse factoring allows a buyer to avoid harming his or her relationship with the supplier.
Suppliers have many reasons why they might appreciate reverse factoring. Many companies pursue invoice factoring on their own, but when one of their buyers takes the initiative, things can be easier for suppliers.
Reverse factoring gives suppliers all the benefits of invoice factoring, but banks usually offer suppliers better deals on reverse factoring than they do on normal invoice factoring. The benefit that matters most to suppliers is the ability to receive 100% of the invoice value instead of a portion.
Suppliers also appreciate having access to their funds without having to wait for the buyer to pay the invoice. Many companies don’t mind selling items to their customers on terms, but doing so can extend their resources in an uncomfortable way. When you’re a buyer, providing the option of reverse factoring to your supplier is often seen as a courtesy.
For banks and factoring companies, reverse factoring is a lucrative enterprise. Banks end up taking in fees from both the buyer and the supplier in this kind of arrangement, which makes these financial institutions even more likely to offer this type of financing.
Real-World Example of Reverse Factoring
Imagine that you’re the head of a fashion startup and you want to buy fabric from a small supplier. While you need this £5,000 fabric order to keep your business growing, you currently don’t have the cash flow to make the purchase outright.
After talking with your bank, you decide that reverse factoring might be the best way to go. Your bank will pay the supplier in full on your behalf, and you’ll pay the invoice amount plus interest at a specified date. You reach out to your supplier, and you come to an agreement.
You go ahead and make the purchase. Your supplier invoices you, and then the supplier promptly sells the invoice to the bank. You tell the bank that you’d like to go ahead with the reverse factoring agreement, and you pay the full invoice amount on the specified date.
If you don’t pay up when the invoice reaches maturity, your supplier won’t lose any money. Instead, the bank will penalise you, and if you go long enough without paying, your bank might start using aggressive collection methods to obtain the invoice value.
Pros and Cons of Reverse Factoring
By this point, you might have noticed that reverse factoring is relatively complicated. This process involves a variety of steps, and it requires the coordination of three separate parties. While reverse factoring has a lot of benefits that you shouldn’t underestimate, it’s important to review the major benefits and detractors of this type of invoice finance before you decide whether it’s right for you.
- Mutually beneficial agreement that rewards the buyer, supplier, and bank.
- Provides buyers with payment flexibility without withholding the funds going to the supplier for the order.
- Suppliers usually get 100% of their invoice value without having to wait.
- Requires the close coordination of the bank, the supplier, and the buyer.
- Not all banks are forthcoming about their fees.
- If you don’t arrange good terms with your bank, reverse factoring can quickly become expensive.
- May require complicated contracts or involve annoying rules.
Reverse Factoring and CreditDigital
CreditDigital is a trade credit solution that cuts through all the red tape and offers the benefits of reverse factoring in a more streamlined package at a lower cost. Here at CreditDigital, we understand that you want to have flexibility in your sales and purchases, but you also don’t want to go through all the hurdles involved in reverse factoring.
When you make sales through CreditDigital, things are easy for both the supplier and the buyer. Our intuitive desktop and mobile interface automates and streamlines many of the processes that banks struggle through on a daily basis. We offer instant approval, and we handle every aspect of credit control to lessen the logistical burden on companies and buyers.
Like reverse factoring, CreditDigital offers suppliers their full invoice value up front. Our platform gives buyers flexibility as they pay back their invoices, but CreditDigital makes this process even easier and more flexible than pursuing reverse factoring from a bank. We offer 0% interest repayment options, and we can give buyers as long as 12 months to pay their invoices.
At CreditDigital, we take everything that’s great about reverse factoring and eliminate any inefficiency to offer buyers and suppliers a financing option that’s easy to use every time. To learn more and get started, visit our vendor portal or our customer portal.
Here are some of the terms you might come across as you research reverse factoring:
Supply Chain Finance
Also known as supplier finance, supply chain finance is any type of finance agreement that provides both a supplier and a buyer with working capital to improve the cash flow of both parties. In these types of agreements, buyers have more time to make a payment on their orders, and suppliers receive the funds they need to operate their businesses immediately.
Invoice factoring is a type of agreement that a supplier makes with a bank to receive early payment on its invoices. In this type of finance solution, the supplier sells its invoices to the bank, and the bank takes over credit control for the invoices. The buyer then pays the bank directly instead of paying the supplier.
In an invoice discounting agreement, a supplier sells its invoices to a bank in exchange for a percentage of the invoice value up front. Unlike invoice factoring, however, the supplier retains full credit control oversold invoices in an invoice discounting agreement.