Just like export finance relates to trade finance as much as to receivables finance, reverse factoring, also known as approved payables finance, is largely a supply chain finance product. Contrary to typical factoring arrangements, this one is initiated not by the supplier of goods, but by the buyer. The intervention of a bank is necessary to make the supplier’s life easier, so it’s important to understand how financial institutions work in this kind of framework.
Although reverse factoring has many advantages, even over factoring, it is not without risks.
How reverse factoring works
With this type of factoring, the buyer initiates the arrangement to solve cash flow problems and banks play a very large part.
Reverse factoring VS “traditional” factoring
Whilefactoring is initiated by the supplier who wants to finance his receivables, reverse factoring is started by the buyer so as to help finance the supplier’s receivables.
The same three parties are involved: ordering party, supplier and factor. Contrary to factoring, the ordering party can choose the invoices that the factor will pay. Here, it’s the buyer’s liability which is engaged.
Buyer approves invoices, finance is raised separately against the accounts payable by the supplier from a financial services provider (usually a bank), who valuates the creditworthiness of the buyer.
Supplier immediately receives 100% of the invoiced amounts from the factor, contrary to factoring arrangements where this amount is discounted, and buyer pays the bank when the invoice is due, plus fees.
Pros and cons of this finance facility
Reverse factoring is a very convenient financial product, even more convenient than factoring, for a number of reasons. However, this solution suffers from several disadvantages.
Advantages of reverse factoring
- faster payments;
- low interest rates as rates are based on the creditworthiness of the buyer.
Ordering parties, or buyers, enjoy:
- better commercial relationships with their core suppliers, leading to possible lower prices;
- time saved from not having to answer their customers’ demands for faster payments;
- total availability of the invoice value for factoring, contrary to discounted amounts involved in traditional factoring.
Reverse factoring is not for any company yet. Disadvantages include:
- Qualified ordering parties are often large companies with AAA credit rating. In fact, this product was invented for large retail groups, known for paying their suppliers only after a very, very long time;
- Agreements can be quite lengthy, with businesses having to commit for up to two or three years sometimes, although the market is changing;
- Suppliers can get trapped in a system where they cannot really choose exactly which invoices will be paid up front;
- Payment orders can’t be cancelled;
- On their side, suppliers may refuse the arrangement because they can find better factoring deal for themselves.