Reverse Factoring Meaning
Reverse Factoring refers to a concept when a firm reaches out to a financial institution to pay its suppliers at a faster rate in exchange for a discount thereby reducing the account receivables time for the suppliers without any credit crunch for the firm which in turn will be paying out to the lender at the end of predefined time duration.
Example of Reverse Factoring
Consider a scenario where a firm wants raw material to fulfill an order in another 2 months. The raw materials required are worth $ 2 million, and the firm does not have any money as of now. Also, as per the terms of the contract, it does not expect any cash inflow for another 2 months. Let’s consider the options the firm has in such scenarios.
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- The firm reaches out to its suppliers and asks for raw materials on credit. It promises them that the invoice will be paid out as soon as it receives cash from its clients. However, that would require at least 2 months. Here supplier might say No or yes, but in both cases, the firm is taking a risk, which eventually puts constraints on its cash flow and balance sheet.
- The second scenario is when the firm reaches out to a lender/bank and works with them to pay out their suppliers. The whole machine consists of the following steps:
- The firm initiates an order for the raw materials with its supplier.
- The supplier reviews the order provides the raw material to the firm, and builds an invoice for the required payment – $ 2 million.
- Firm reviews and confirms the payment, confirming the lender that it will pay the required amount at maturity, in our case at the end of 2 months.
- The supplier then sells this invoice contracts to the lender at an agreed discount (Let’s say 5%).
- The supplier receives the account receivables in real-time and need not have to wait for 2 months.
- At maturity, the firm (buyer) makes the payment to the lender/financial institution.
Please note that since the lender has been arranged by the firm, hence the payment paid out to the supplier, and the discount will be based on the creditworthiness of the firm.
Advantages of Reverse Factoring
Below are the advantages of Reverse Factoring.
- Invoices are paid to suppliers much faster, avoiding any delay in receiving account receivables. This leads to improved cash flow in the system, which can be put to generate more profitability.
- Since invoices are paid on time, suppliers no need to chase the firms for early requests. Both parties can focus on their core activities rather than focussing on payment schedules or delays. Undoubtedly, this will lead to better management and better utilization of resources.
- The concept of reverse factoring is an agreement between the bank and the firm and not between the suppliers. The terms and interest rates are aligned with the creditworthiness of the firm without impacting the suppliers.
- Reverse factoring is an off-balance sheet mechanism and, in turn, makes the balance sheet looks good by having better ratios like working capital turnover, trade payable turnover for the firm keeping both investors and shareholders happy.
Disadvantages of Reverse Factoring
The following are a few disadvantages of Reverse Factoring.
- The agreement of reverse factoring depends a lot on forecasting the sales and the anticipation that the buyer/firm would be able to make a trade and return the invoice amount to the bank with a prespecified interest rate after a certain period of time. If this does not happen, then banks will be at a loss, and due to the regulatory scrutiny might take away the collateral leading to a credit crunch situation for the firm. This scenario can lead to a much worse condition as the funds for the firm may dry up when it needs the most.
- If not arranged properly, it can lead to being very expensive for the firm as it may require complicated contracts and ambiguous rules.
Important Points to Note
- Reverse factoring is a supply chain optimization mechanism that helps in better collaboration between the participants. Because of the timely payments, it helps in resolving any disputes and develops better relationships between the firm and its suppliers.
- The eventual goal of reverse factoring is to reduce the time for account receivables and hence improve cash flow. A cost-effective mechanism reduces any constraint on the firm as well as its suppliers.
- Reverse factoring has already disrupted the industry. Although started with the automobile industry, it has done wonders in many capitals intensive industries like aerospace, pharma, telecom, consumer packaged foods, chemicals, etc. In fact, there are many fintech firms trying to explore this avenue further. Many consulting firms in their independent research have estimated the reverse factoring market around the US $ 255 -285 billion ( 2015 estimate). However, the astonishing part of this research is that size is currently on 3% and has the potential to reach 20-25% of the industry’s accounts payable in the near term.
- Reverse factoring only makes sense if the rate of interest or discount offered by the intermediary financial institution is low, and based on the credit rating of the firm rather than the supplier else. It is just a delayed overhead.
- Reverse factory benefits can be quantified based on the models that study the ecosystem by optimizing the accounts payable. The results suggest that 25 – 45% value is captured by the supplier, and 35-45% is captured by the buyer while the remaining 15-20 % is captured by the financial institution.
Conclusion
Reverse factoring is a part of supply chain finance aimed at removing the frictions in the ecosystem and leading to a better flow of cash in a faster and more efficient way by focussing on one of the major touch points between the suppliers and firms – accounts payable. Unlike factoring, it is initiated by the firm rather than the suppliers to finance their account receivables. If implemented correctly, it can help in improving liquidity in the system, better cash circulation, timely payments, fewer defaults, and eventually better profit-generating capabilities for the firm as well as its suppliers.
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