What is factoring?
Factoring or accounts receivable factoring is a type of transaction in which a business/seller sells its accounts receivable to a third-party factoring company at a discount. This process allows the business to immediately convert their receivables into cash, improving liquidity and enabling them to meet short-term financial obligations without waiting for customer/buyer payments.
Unlike traditional loans, this process doesn’t involve creating debt for the company. Instead, it’s a form of asset-based financing, where the company’s receivables serve as the asset. The factor advances a significant percentage of the invoice value (typically 70% to 85%) and then takes the responsibility of collecting payments from the customer.
It’s especially useful for companies with long payment cycles or those experiencing rapid growth. In these cases, waiting for customer payments could hinder their operations; thus factoring is employed. It not only improves cash flow but also reduces the risk associated with non-payment, as factors often assume the credit risk of the receivables.
What is reverse factoring?
Reverse factoring is a financial arrangement where a buyer initiates the process to help their suppliers get paid faster by a third-party financial organisation. In this setup, the buyer (who is generally a large company), arranges for a bank or factoring company to pay their suppliers promptly on their behalf.
The financial institution then collects the payment from the buyer on the agreed-upon due date. Because the buyer typically has a strong credit profile, the financial institution offers this service at lower financing costs than the supplier could obtain on their own.
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Reverse factoring vs factoring: the difference
1. Initiation of the process:
In factoring, the supplier or the seller initiates the process. They sell their receivables to a financial institution. In reverse factoring, the buyer initiates the process where it arranges for a factoring company/bank to pay their suppliers quickly.
2. Party that gets benefitted:
Although both pirates get benefitted because of these transactions but in factoring, it’s the supplier who gets the most benefit because its receivables are coveted into immediate cash. Reverse factoring focuses on the buyer’s desire to support their suppliers. It benefits the supplier by providing faster payments but is driven by the buyer’s need to maintain a healthy supply chain.
3. Credit risk:
In factoring, the factoring company assesses the creditworthiness of the supplier’s customers because the repayment risk lies with those customers. In reverse factoring, however, the financial institution assesses the credit risk of the buyer, not the supplier, since the buyer is responsible for repayment.
4. Cost of the process:
The cost is typically higher in factoring because the supplier’s credit risk along with their customers, is often greater than the buyer’s. It’s usually between 1% to 5% of the invoice value.
Reverse factoring offers lower financing costs because it relies on the buyer’s strong credit profile. We discussed earlier that it’s often initiated by a buyer who is a large and creditworthy company.
The differences are shown in the table below as well.
| Criteria | Factoring | Reverse factoring |
|---|---|---|
|
Initiation of the process |
The supplier initiates the process by selling receivables to a financial institution. |
The buyer initiates the process by arranging for the factoring company to pay their suppliers quickly. |
|
Party that benefits most |
Supplier benefits most by converting receivables into immediate cash for better liquidity. |
Buyer benefits by maintaining a healthy supply chain, while suppliers benefit from faster payments. |
|
Credit risk |
Credit risk is assessed on the supplier’s customers, as they are responsible for repayment.
|
Credit risk is assessed on the buyer, as they are responsible for repayment to the financial institution. |
|
Cost of the process |
Typically higher (1-5% of invoice value) due to the higher credit risk associated with suppliers and their customers.
|
Generally lower, as it relies on the buyer’s strong credit profile, often a large and creditworthy company. |
Benefits of reverse factoring for businesses
Reverse factoring comes with various advantages just like factoring.
- Improved cash flow for suppliers:
In traditional invoicing, suppliers often wait 60-90 days to receive payment from buyers. Reverse factoring addresses this issue by allowing suppliers to receive payment as soon as they issue an invoice.
This immediate cash helps them cover their running expenses and invest in new opportunities without needing to opt for high-interest bank loans.
- Relationships with buyers improve:
The prompt payment by reverse factoring can significantly improve the relationship between buyers and suppliers. Suppliers value the reliability of getting paid early, which can translate into more favourable terms for the buyer such as discounts.
This stronger relationship fosters greater collaboration and trust, which is crucial in industries where supply chain reliability is pivotal.
- Lower financing costs:
Financing costs are typically lower in reverse factoring because the financing is based on the buyer’s creditworthiness rather than the supplier’s. Buyers can secure better interest rates compared to what suppliers might obtain on their own.
This reduction in cost is passed on to the suppliers, making reverse factoring a more affordable financing option. This helps suppliers improve their profit margins as well.
- Off-balance-sheet financing:
Reverse factoring can be structured as off-balance-sheet financing which means it does not appear as debt on the buyer’s balance sheet. This allows them to improve their financial ratios such as debt-to-equity, without the need to reduce their actual debt levels.
As a result, it makes the company appear more financially stable and attractive to lenders, potentially lowering the cost of capital further. For suppliers, this arrangement offers the benefit of early payment without debt, preserving their borrowing capacity for other needs.
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Reverse factoring can be costly for suppliers, as they might pay fees for early payments. Additionally, it depends heavily on the buyer’s creditworthiness, and if the buyer defaults, it can lead to complications.
No, reverse factoring and confirming are not the same. Reverse factoring involves the buyer initiating early payments to suppliers through a financial institution. Confirming is a broader process where a third party handles the payment of invoices but doesn’t necessarily offer early payment options.
Since it’s the supplier who receives early payment from the bank or factoring company through reverse factoring, it will be him who will pay for the fee.
