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Reverse factoring is an accounting solution that can help businesses to access the working capital they need to continue their everyday operations. Also known as supply chain financing, reverse factoring describes the process of a bank or financial company agreeing to pay a company’s outstanding invoices to their suppliers who may be willing to accept a lower sum in exchange for prompt payment of their receivables.
It’s all too easy for money to get trapped in the supply chain, and it isn’t good for anyone when this happens. Reverse factoring via an intermediary finance provider can free up cash flow and help both supplier and purchaser to go about their business without the added constraints of outstanding invoices. Here we take a more in-depth look at how reverse factoring works and how it could be of benefit to your business.
How does reverse factoring work?
Reverse factoring is a process that involves three parties – a supplier, a buyer, and a third-party finance company. The arrangement will typically begin when the supplier sends an invoice to the buyer for services rendered or products sold. The buyer will then approach the finance company to arrange for reverse factoring – whereby the finance company will settle the invoice with the supplier taking their fee from the overall amount owed. In time, the buyer will repay the finance company for the cost of the invoice.
Example of reverse factoring
To give a simplified example of how reverse factoring works, let's imagine a printing company that has a well-established relationship with its ink supplier. The printing company needs to have money in the bank (working capital) to grow, but because the ink supplier requires a fast turnaround on the payment of its invoices, it’s difficult for the printers to build up any capital – leaving their income and growth trajectory stagnant.
The thing is, the ink company needs fast and reliable payments in order to keep their cash flow up and to ensure they have the working capital to succeed and grow. If customers fail to pay on time, trading becomes difficult and this is where reverse factoring comes into play. When the ink company next invoices the printers, they can either wait through their payment term to get paid, or (for a small fee) they can access early repayment via the agreement set up between the printers and a finance company.
In sum, this means that the ink company gets paid early and the printers have a longer repayment term over which to settle the outstanding invoice. This leaves both parties with more working capital and allows them to manage their cash flow more effectively.
Why do people need reverse factoring?
Managing cash flow can be difficult, and reverse factoring works by freeing up capital for both suppliers and buyers. Suppliers benefit because they are paid more quickly than might otherwise be the case, leaving them with a better cash flow and higher levels of working capital to continue operating and growing their business. The buyer also benefits because they will generally have a longer period over which to repay the finance company than would be the case if they had paid the invoice themselves. This means that, at least in the short term, they have better access to working capital and can manage their books more efficiently.
What is the difference between invoice discounting and factoring?
Invoice factoring is a short-term, external financing solution that involves selling your outstanding invoices to a finance company as a way of improving cash flow. The finance company will purchase a business’s receivables for slightly less than their full worth and will then take on responsibility for collecting what is owed. This means that suppliers do not have to wait for their customers to pay in order to get the working capital they need to operate and grow. Invoice factoring comes in two major forms, recourse – where responsibility for non-payment of the invoice is passed back to the supplier business – and non-recourse – where the business will not have to take back responsibility for the invoice in certain circumstances.
Invoice discounting is an alternative form of short-term borrowing taken out against your outstanding invoices. Discounting looks much more like a traditional loan arrangement, in the sense that money is borrowed against your business’s receivables. The business maintains responsibility for its sales ledger, invoice processing and payment chasing. To this end, invoice discounting makes it much less likely that your customers will become aware of your relationship with the finance company.
What is the difference between factoring and reverse factoring?
Reverse factoring works on the basis of a three-way agreement between a financing company, a supplier, and a purchaser. Without the involvement of all three parties it simply couldn’t work, as the finance company must agree to pay the buyer’s outstanding invoice whilst agreeing on money off the total owed to the supplier in return for making payment faster than had originally been agreed.
Invoice financing and traditional factoring, on the other hand, involve a supplier selling their outstanding invoices to a finance company who then assumes responsibility for collecting the sums owed.
What's the difference between reverse factoring and invoice financing?
Invoice financing is the blanket term used to describe borrowing based on what a business is owed by its customers. The main types of invoice financing are invoice factoring and invoice discounting.
Reverse factoring, on the other hand, is usually initiated by a buyer rather than a business with outstanding receivables. They will arrange for a finance company to pay what they owe (less a fee) in short order and much more quickly than would be the case if the business were to pay themselves. This is intended to improve the cash flow of the buyer, but also of the supplier business who benefits from better levels of working capital as they do not have to wait for their payment terms to elapse to receive what they are owed.
What are the benefits of reverse factoring?
The ultimate aim of reverse factoring is to speed up accounts receivables and increase cash flow for businesses at different levels of the supply chain. Whilst it does mean paying a small fee for each invoice that’s paid early by a financing company, reverse factoring has many benefits, including:
Fewer early payment requests from suppliers, as they can access the money they’re owed quickly and efficiently. This means that cash flow issues further up the supply chain no longer have to trickle down to buyers who might otherwise receive a demand for payment.
Suppliers get paid sooner, meaning that they are able to more effectively manage their own cash flow and use the working capital they receive to operate and grow.
Improved buyer/supplier relationships, as all of the stress from chasing up on unpaid invoices is removed. When financial dealings are settled with the finance company, both the supplier and the buyer can work on what they do best and establish a closer working relationship.
Longer payment terms for the buyer, who may have considerably longer to pay an invoice than would otherwise be the case. These terms are usually set with reference to the buyer’s relative creditworthiness.
In all, reverse factoring can improve cash flow and enhance business relationships throughout the supply chain.
If this sounds like it could be of use to your business, why not find out more and compare the market’s very best factoring and invoice financing options at BusinessComparison. From invoice finance to commercial mortgage and cash advances, you could get the financial support that your business needs, at a rate that suits you.
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