Great question. Though perhaps in coming to an answer, it is important to have a basic understanding of what factoring is.
What Is Factoring?
Factoring is a type of debtor finance and financial transaction whereby a supplier sells its invoices to a third-party (i.e. a factor) at a discount. It is often used by businesses who want to factor their receivable assets to meet their immediate cash flow needs. Importantly, factoring is not the same thing as “invoice discounting”. Factoring is very specifically the actual true sale of receivables, whereas invoice discounting is a loan whereby the accounts receivable (AR) assets are used as collateral.
Accounting Tools offers the following definition: “Reverse factoring is when a finance company, such as a bank, interposes itself between a company and its suppliers, and commits to pay the company’s invoices to the suppliers at an accelerated rate in exchange for a discount.”
Reverse factoring (also known as approved payables finance) works in a slightly different way to traditional factoring. Factoring occurs when a supplier wants to finance his receivables, whereas reverse factoring is a financing solution that is initiated by the buyer in order help finance the supplier’s receivables more easily, and at a lower rate, than what they would normally be offered. Reverse factoring is one of the key initiatives in successful supply chain finance (SCF).
Reverse factoring allows suppliers to receive discounted payments of invoices which are due to be paid by a buyer (i.e. an account payable (AP)). Once the buyer has approved the invoice for payment, the finance is raised separately against the AP by the supplier from a finance provider (usually a bank), who relies on the creditworthiness of the buyer. The buyer will pay the finance provider at the agreed invoice due date, and the supplier receives a much prompter discounted payment from the financer. Since the buyer is often a large company with a very high-quality credit rating, it is their liability that is engaged, which therefore means that the interest that is applied is much lower than what the supplier could have obtained on its own. (See Figure 1 below).
Reverse factoring is similar to factoring in that it involves the same three parties: the ordering party, the supplier, and the factor. Just as with traditional factoring, the purpose is to finance the supplier’s receivables by a factor so that the supplier can cash in the money immediately for what he sold (minus the interest that is deducted by the factor to finance the advance of payment).
Where reverse factoring differs, however, is that it is the ordering party (a company that is a buyer) who initiates the process, as it chooses the invoices that it will allow to be paid earlier by the factor. Because it is the ordering party that starts the process, it is that company’s liability that is engaged, which then enables the deduction on the interest that the supplier would not have been able to attain on his own.
The Benefits Of Reverse Factoring For Suppliers:
- Suppliers who are struggling with cash flow can be paid much earlier than normal.
- The interest rate is normally low, since it is based on the credit standing of the paying company rather than the supplier.
The Benefits Of Reverse Factoring For Ordering Parties (Buyers)
- Close links with its core group of suppliers can be fostered since the suppliers benefit greatly in terms of accelerated cash flow.
- 100% of the invoice is available for factoring, rather than the discounted amount that is normally available when using traditional factoring methods.
- The ordering party no longer has to fend off requests from suppliers for early payments, as they are now being paid as soon as possible.
Reverse factoring is the payment solution that creates the win-win scenario that the supply chain craves, and, though still rare today, more and more we will see this method in use as an effective cash flow optimization tool, especially for those companies who outsource a large volume of goods and services.
The Traxpay B2B Dynamic Payments platform, and its ability to bring factors, buyers, and suppliers together, with full transparency to transaction data and banking/payments, simplifies factoring and reverse factoring for buyers and suppliers, and enables a new class of strategic financial tools to better manage the most important asset for a business – its cash.