In reverse factoring, the buyer arranges for the seller to be paid by a bank. This has advantages for both the buyer and the seller. Find out here what these are and how reverse factoring works exactly.
What is reverse factoring in banking?
In reverse factoring, a third party (e.g. a bank or other financier) pays the seller on behalf of the buyer. This is often used in the business environment when companies commission reverse factoring to pay their suppliers.
Reverse factoring vs. factoring
In reverse factoring, the buyer of goods initiates the factoring contract. Therefore, it is exactly the reverse process to factoring, where the seller assigns his receivable to a factoring service provider, receives payment from the latter and the service provider then takes care of collecting the receivable from the buyer.
Reverse factoring arrangement or agreement
In reverse factoring, an agreement is first made between the buyer and the seller, because the seller must agree to payment through reverse factoring. Then the buyer concludes a contract with a bank or a reverse factoring provider in which the conditions are specified.
Among other things, the contract contains information about the fees for the service and when the buyer has to pay the provider. In most cases, a date is negotiated that is later than the due date of the actual invoice, so that the buyer can push the due date further into the future and preserve his liquidity for longer.
How does reverse factoring for companies work?
Reverse factoring is often used by companies when they want to offer their suppliers early payment, but themselves want to hold back the money for payment even longer. The reverse factoring provider thus acts as a lender: He pays the supplier immediately, and is then paid at a later date by the ordering company.
Reverse factoring: example
A company wants to order raw materials for production from its supplier. It needs the materials as soon as possible and therefore wants to gain a delivery advantage by offering early payment. However, so that liquidity is not burdened by the early payment, the company decides to use reverse factoring.
The supplier agrees, and the company approaches a reverse factoring provider to conclude a contract. It negotiates that the supplier will be paid immediately after its invoice is received and that it has 90 days to pay the provider.
After the contract is concluded, the company places the order with its supplier. The supplier delivers the materials as quickly as possible and sends the invoice to the reverse factoring provider, who settles it immediately.
The company now has enough raw materials for its production and does not have to pay for the goods for another 90 days, which spares its liquidity. During this period, it can generate more income by selling the manufactured products, so that paying the provider at the future date does not put too much strain on its liquidity.
Benefits & drawbacks of reverse factoring for supply chain finance
Benefits of reverse factoring
Reverse factoring can benefit both buyers and sellers in several ways. The biggest advantage for buyers is that they can negotiate a longer payment term with the reverse factoring provider than their supplier would grant them. Because the supplier is also secured in his payment and receives it immediately, the buyer can negotiate better delivery conditions.
The relationship between buyer and seller is strengthened as the reverse factoring provider acts as an intermediary to ensure a smooth payment process. In this way, long-term supply contracts can be concluded that ensure security of supply for the buyer.
If the buyer enters into a reverse factoring agreement for several suppliers, he also has less hassle when it comes to payment: instead of paying each supplier individually, he only pays the reverse factoring provider.
For sellers, reverse factoring provides security in two ways: They get paid immediately, which allows them to maintain their liquidity, and they can be sure that they will receive payment.
Drawbacks of reverse factoring
Reverse factoring can be disadvantageous for the buyer if his company's income collapses, e.g. due to a decline in customer demand. If the company is then no longer able to make the payment to the reverse factoring provider, the latter will terminate the contract, even if further payments lie in the future.
The result: a large amount of debts to be settled in the short term, which the company still has to pay "on top". A company that is already struggling financially can very quickly find itself on the brink of insolvency.
The disadvantages for sellers are that they have to accept the buyer's terms when agreeing to the reverse factoring programme. This gives them less freedom to set their own payment terms, especially if the buyer is one of the main customers on whom they depend.