Reverse Factoring is a method of alternative commercial finance where the supplying party (client) has it’s receivables finance by an early payment arrangement set up by the ordering party. Typically, the strong credit of the ordering party helps their suppliers receive more favorable financial terms than they would have otherwise received in a traditional factoring arrangement.
Reverse factoring is seen as an effective cash flow optimization tool for companies outsourcing large volume of services (e.g. clinical research activities by Pharmaceutical companies). The benefit to both parties is that the company providing the services can get the outstanding value of their invoices paid in 10 days or less vs. the normal 30- to 45-day payment terms while the ordering party can delay the actual payment of the invoices (which are paid to the bank or factor) by 90 to as much as 180 days thus increasing cash flow. After the initial period of cash flow optimization, it is unclear if this will remain of value to the ordering party because you will then be paying monthly invoices of approximately equal amounts assuming your outsourced services are stable/average across the year/future periods.
Reverse factoring is similar to traditional advance factoring insofar as it involves three parties: the ordering party (customer), the supplier (the client), and the factor. Just as in traditional factoring, the aim of the process is to finance the supplier’s receivables by a financier (the factor), so the supplier can receive the money for what he sold immediately (minus the fee the factor deducts to finance the advance of money).
Contrary to traditional advance factoring, the initiative to set up the factoring arrangement is NOT from the supplier, the party that would have presented invoices to the factor to be paid earlier. This time, it is the ordering party (customer) that starts the process – usually a large company – choosing specific invoices that will be allowed to be paid earlier by the factor. Often, the manufacturer / distributor will offer some form of “Quick Pay” to all suppliers who will agree to a small discount for the immediate payment. It is therefore a really collaborative project between the ordering party, the suppliers of the ordering party, and the factor.
Because it is the very creditworthy ordering party that typically starts the process, it is their liability for payment. Because they are typically the strongest credit, the factoring fees that would normally be charged to the supplier will be less than what the supplier would be charged if he had initiated the arrangement on his own.
Advantages to the Supplier
The supplier has its invoices paid earlier; therefore it can more easily manage its cashflow, and reduce by the way the costs of receivables management. Moreover, as it is the ordering party (manufacturer or distributor) that puts its liability at stake, the supplier often benefits from a better interest rate on the trade discount than the one that would have been obtained by going directly to a factoring company. Reverse factoring is very useful for large companies that have large groups of small clients, because it creates a more durable business relation when the big company helps the smaller one, and doing so gets some extra money. In a factoring arrangement involving reverse factoring, there is seldom any problem concerning the payment of the invoice, since the invoice must be approved for early payment by the ordering party and is, in effect, verified. In the reverse factoring process, as it concerns verified invoices, as soon as the supplier receives the payment from the factor, the factor is protected so long as the ordering party is creditworthy.
Advantages for the Ordering Party
For the ordering party, reverse factoring permits all the suppliers to be financed by a single factor / bank, and that way the ordering party can pay one company instead of many, which eases the invoicing management. The relation with the suppliers benefiting of the reverse factoring is improved because they benefit from a better financing solution, and their payment delays are reduced. Offering suppliers such pre-payment opportunities can be a powerful incentive and attract higher quality suppliers and also ensure a more durable and lasting relationship with the suppliers. Moreover, it ensures that the suppliers will be able to find advantaging financing in case of cash flow problem. In some cases, offering reverse factoring assures that hard to replace suppliers will stay in business, and are reliable.
Advantages to the Factor
The factor in a reverse factoring arrangement obviously benefits due to the fact that it will source multiple new clients with a single sales presentation. Additionally, the need for invoice verification will become almost non-existent since the customer (ordering party) will submit all approved invoices for “quick pay” directly to the factor.