Reverse Factoring Meaning Examples What Is 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 two months. The raw materials required are worth $ 2 million, and the firm does not have any money. Also, as per the contract terms, it does not expect any cash inflow for another two months. Let’s consider the options the firm has in such scenarios.

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 two months. Here the supplier might say No or yes, but in both cases, the firm is taking a risk, which eventually puts constraints on its cash flow andA 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 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.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 to the lender that it will pay the required amount at maturity at the end of 2 months.The supplier then sells these invoice contracts to the lender at an agreed discount (5%).The supplier receives the account receivables in real-time and must not wait for two months.At maturity, the firm (buyer) makes the payment to the lender/financial institutionFinancial InstitutionFinancial institutions refer to those organizations which provide business services and products related to financial or monetary transactions to their clients. Some of these are banks, NBFCs, investment companies, brokerage firms, insurance companies and trust corporations. read more.

Please note that since the firm has arranged the lender, the payment will be paid out to the supplier, and the discount will be based on the creditworthinessCreditworthinessCreditworthiness is a measure of judging the loan repayment history of borrowers to ascertain their worth as a debtor who should be extended a future credit or not. For instance, a defaulter’s creditworthiness is not very promising, so the lenders may avoid such a debtor out of the fear of losing their money. Creditworthiness applies to people, sovereign states, securities, and other entities whereby the creditors will analyze your creditworthiness before getting a new loan.read more of the firm.

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 to the lender that it will pay the required amount at maturity at the end of 2 months.The supplier then sells these invoice contracts to the lender at an agreed discount (5%).The supplier receives the account receivables in real-time and must not wait for two months.At maturity, the firm (buyer) makes the payment to the lender/financial institutionFinancial InstitutionFinancial institutions refer to those organizations which provide business services and products related to financial or monetary transactions to their clients. Some of these are banks, NBFCs, investment companies, brokerage firms, insurance companies and trust corporations. read more.

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Advantages of Reverse Factoring

Below are the advantages of Reverse Factoring.

Invoices are paid to suppliers much faster, avoiding delays in receiving account receivables. It leads to improved cash flow in the system, which can generate more profitability.Since invoices are paid on time, suppliers do not need to chase the firms for early requests. Both parties can focus on their core activities rather than 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 firm’s creditworthiness without impacting the suppliers.Reverse factoring is an off-balance sheetOff-balance SheetOff-balance sheet items are those assets that are not directly owned by the business and therefore do not appear in the basic format of the balance sheet. However, they tend to impact the financials of the company indirectly.read more mechanism. In turn, the balance sheet looks good by having better ratios like workingCapital turnover determines the organization’s capital utilization efficiency and is calculated as a ratio of total annual turnover divided by the total amount of stockholder’s equity. The higher the ratio, the better the utilization of the capital employed.read more capital turnoverCapital TurnoverCapital turnover determines the organization’s capital utilization efficiency and is calculated as a ratio of total annual turnover divided by the total amount of stockholder’s equity. The higher the ratio, the better the utilization of the capital employed.read more, and trade payable turnover for the firm to keep 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. 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 be 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 improve cash flowCash FlowCash Flow is the amount of cash or cash equivalent generated & consumed by a Company over a given period. It proves to be a prerequisite for analyzing the business’s strength, profitability, & scope for betterment. read more. A cost-effective mechanism reduces any constraint on the firm and its suppliers.Reverse factoring has already disrupted the industry. Although it started with the automobile industry, it has done wonders in many capital-intensive industries like aerospace, pharma, telecom, consumer packaged foods, chemicals, etc. Many fintech firms are trying to explore this avenue further. In their independent research, many consulting firms have estimated the reverseA factor market is a resource market that allows business firms to purchase factors of production such as land, labor, raw materials with which they produce goods and services. In simple words, it is a market for the factors of production.read more factoring marketFactoring MarketA factor market is a resource market that allows business firms to purchase factors of production such as land, labor, raw materials with which they produce goods and services. In simple words, it is a market for the factors of production.read more to be around the US $ 255 -285 billion ( 2015 estimate). However, the great part of this research is that size is currently at 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. It is just a delayed overhead.Reverse factory benefits can be quantified based on the models that study the ecosystem by optimizing the accounts payableAccounts PayableAccounts payable is the amount due by a business to its suppliers or vendors for the purchase of products or services. It is categorized as current liabilities on the balance sheet and must be satisfied within an accounting period.read more. The results suggest that the supplier captures 25 – 45% of the value, and the buyer captures 35-45%, while the financial institution captures the remaining 15-20 %.

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 faster and more efficiently 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 improve liquidity in the system, better cash circulation, timely payments, fewer defaults, and eventually better profit-generating capabilities for the firm and its suppliers.