Reverse Factoring

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.

  1. 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 sheetBalance SheetA balance sheet is one of the financial statements of a company that presents the shareholders' equity, liabilities, and assets of the company at a specific point in time. It is based on the accounting equation that states that the sum of the total liabilities and the owner's capital equals the total assets of the company.read more.
  2. 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:

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.

Reverse-Factoring

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Source: Reverse Factoring (wallstreetmojo.com)

Advantages of Reverse Factoring

Below are the advantages of Reverse Factoring.

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

Conclusion

Reverse factoring is a part of supply chain financeSupply Chain FinanceSupply Chain Finance, also called Reverse Factoring, is an arrangement in which the supplier gets advance payment for receivables through a financier on behalf of the buyer. It provides significant benefits for both the buyer & the supplier. read more 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.

This has been a guide to Reverse Factoring and its meaning. Here we discuss an example of reverse factoring with a scenario along with advantages and disadvantages. You may learn more about our articles below on Finance –

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