Reverse factoring and supply chain finance explained

We take a closer look at reverse factoring to consider how it can free up much-needed working capital – and improve working relationships – for suppliers and buyers alike.

By Matt Ayres on 17/07/2019

A dairy farm could use a reverse factoring arrangement with a cheese company to unlock working capital for both parties | iwoca

Reverse factoring is a financing solution designed to help buyers and suppliers access the working capital they need for day-to-day operations. When researching it, you might also come across terms like supply chain finance, supplier finance and supply chain funding. In general, these are all just slightly different ways of referring to reverse factoring.

Why do people need reverse factoring?

Almost all businesses have struggled with cash flow at some point due to supply chain issues. Reverse factoring allows business owners to access the working capital they need, when they need it.

Having working capital trapped in supply chains can have a detrimental effect on the cash flow of businesses and their suppliers. Using an intermediary finance provider to free up cash flow and provide timely access to finance on both sides can help daily operations run smoothly.

How does reverse factoring work?

In a successful reverse factoring relationship, the buyer gets to wait longer before paying what they owe their supplier, and the supplier has the option of receiving early payment from the finance provider, minus a small fee.

It works thanks to the involvement of three parties: the buyer, the supplier and the finance provider, and is designed to create a win-win situation for everyone.

This frees up working capital for both the buyer and the supplier, while the finance provider makes money for every invoice that’s paid early by taking a small percentage of the amount owed. Since the supplier can choose which invoices it ‘sells’ to the finance provider in exchange for an early payment fee, it’s a flexible arrangement that can be optimised to meet the needs of a company’s current financial situation.

Reverse factoring is particularly useful when the buyer has a better credit rating than the supplier, since it allows the supplier to access lower rates for early paid invoices. The buyer also benefits, since their good credit rating makes it more likely for the finance provider to agree a longer repayment period for the supplier’s invoices.

What's the difference between reverse factoring and invoice financing?

With reverse factoring, there are three parties involved: the original supplier, the original buyer, and the lender or bank who are settling the outstanding invoice. With reverse factoring, a bank or lender pays the outstanding invoice owed to a supplier faster than originally agreed, in exchange for money off the total owed. With traditional invoice financing or factoring, it's the supplier who requests finance by leveraging the value of an outstanding invoice.

Invoice financing is similar to reverse factoring, but it's the buyer who requests the finance from the lender or bank.

Example of supply chain finance

Reverse factoring or supply chain finance can be best explained with an example. Let’s imagine the fictional company Big Cheese Ltd has a long term relationship with its supplier, Cowabunga Dairy Farm.

As the owner of Big Cheese Ltd, Mr Smith needs access to working capital that will help his business grow. Problem is, with suppliers like Cowabunga Dairy Farm needing fast payment for every order placed, Mr Smith is low on working capital, and his company growth has come to a standstill.

On the other side, Ms Jones of Cowabunga Dairy Farm needs fast and reliable payments from her buyers to access the working capital she needs for her business (buying cows and the like). When buyers fail to pay on time, her financial situation gets messy. So when Mr Smith from Big Cheese Ltd proposes a reverse factoring arrangement, she agrees to give it a try.

The following week, Big Cheese Ltd places a large order for some milk, which Ms Jones from Cowabunga Dairy Farm is happy to fulfil. When she sends her invoice to Mr Smith, Ms Jones can either wait the usual 30 days to be paid, or access an early repayment thanks to the reverse factoring agreement Mr Smith has set up with his finance company.

All Ms Jones needs to do is log in to an online system and select the invoice she wants to be paid early, with the proviso that a small fee will be deducted to pay the finance company.

Mr Smith is pretty pleased with this arrangement too, since the finance provider has seen his good credit rating and agreed to double the usual 30-day credit period he has with his suppliers. As a result, he now has 60 days to pay any outstanding invoices, unlocking working capital that can be used in other areas of his business.

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Quick fire facts

  • Reverse factoring requires the involvement of a buyer, a supplier and a finance provider, and benefits everyone involved

  • The supplier can choose to have its invoices paid more quickly via the finance provider, who will deduct a small fee for early repayments

  • The buyer extends the amount of time they need to pay invoices, keeping working capital within their business for longer

  • This arrangement can help to avoid a competitive relationship between buyer and supplier, where the buyer seeks to negotiate longer payment terms in direct opposition to the supplier’s need for fast payment

  • Sometimes described as supply chain finance, supplier finance or supply chain funding

In summary

Reverse factoring can be an effective way of fostering trusting, long-term relationships between companies and their suppliers. By using a finance provider to unlock working capital on both sides, it gives suppliers the freedom to choose how quickly they get paid while allowing buyers a longer period to settle invoices.