What Is Reverse Factoring & How Does It Work?

Supply chain finance optimizes cash flow and manages working capital for businesses and their partners. Reverse factoring is a prominent financial tool within this field. This buyer-initiated approach provides early payment options to suppliers, leveraging the buyer’s financial strength. It enhances the financial stability of the entire supply chain, benefiting all participants by streamlining payment processes and improving cash flow.

What is Reverse Factoring

Reverse factoring, also known as supply chain finance or supplier finance, is a financial solution where a buyer facilitates early payment for their suppliers through a third-party financial institution. It optimizes supplier cash flow by leveraging the buyer’s stronger creditworthiness.

A financial institution pays the supplier’s approved invoices early, typically at a small discount. This allows the supplier to receive funds faster than standard payment terms, such as 30, 60, or 90 days. The buyer then repays the full invoice amount to the financial institution on the original due date, or later if extended terms are negotiated.

Suppliers access capital at a lower cost, as the financing rate is based on the buyer’s credit rating. The buyer benefits by potentially extending their own payment terms, holding onto cash longer. This creates a mutually beneficial system that enhances working capital for both parties and can reduce supply chain disruptions.

How Reverse Factoring Works

The process begins with the buyer establishing a program with a financial institution (funder). The buyer’s strong credit rating enables favorable financing rates for suppliers. The buyer purchases goods or services, and the supplier issues an invoice.

The buyer reviews and approves the invoice, then uploads the data to a platform or transmits it to the funder. The supplier accesses this platform and can choose to request early payment on approved invoices.

If the supplier opts for early payment, the funder transfers the invoice amount, minus a small financing fee (typically 1% to 5%), directly to the supplier’s bank account, often within days. On the original or extended due date, the buyer pays the full invoice amount to the financial institution. The buyer repays the funder the total sum, regardless of whether the supplier opted for early payment.

Key Parties Involved

A reverse factoring arrangement involves three primary parties.

The Buyer is typically a large corporation with a strong credit rating. They initiate the program to optimize their working capital, potentially extending payment terms, and to strengthen supplier relationships.

The Supplier provides goods or services to the buyer. They participate to gain early access to cash from approved invoices, improving liquidity and managing operational expenses. This provides cash flow predictability.

The Funder, usually a bank or specialized financial institution, provides capital for early payments. Their motivation is to earn fees and establish a stable revenue stream. Funders assess the buyer’s creditworthiness, as the buyer is responsible for repayment, allowing them to offer attractive rates.

Reverse Factoring Versus Traditional Factoring

Both reverse factoring and traditional factoring involve a third party purchasing invoices, but they differ in initiation, focus, and leveraged creditworthiness.

Traditional factoring is supplier-initiated. The supplier sells accounts receivable to a factor at a discount to obtain immediate cash and improve liquidity. Financing cost is based on the supplier’s creditworthiness.

Reverse factoring is buyer-initiated. The buyer sets up the program to benefit suppliers. The funder assesses the buyer’s credit risk, which is usually stronger, leading to lower financing costs for the supplier.

Traditional factoring primarily serves the supplier’s immediate cash flow needs. Reverse factoring, while benefiting suppliers, is a strategic tool for buyers to strengthen their supply chain, ensure supplier stability, and potentially extend their own payment terms.