If a business needs a bit more time to pay its suppliers, there are financing options available that give teams extra flexibility, while still ensuring suppliers receive on-time payments for what they’re owed.
Reverse factoring is one such option, with customers organizing financing through a third-party financial institution. Curious to learn more? In this guide, we’ll cover the basics of reverse factoring, how it works, the benefits it offers, and when it might be used over traditional financing methods.
Reverse factoring definition
Reverse factoring is a type of financing that customers use to pay suppliers for an order they’ve made. This type of arrangement may also be referred to as supply chain financing or accounts payable financing.
Customers might initiate reverse factoring for a number of reasons, like when they need more time to pay suppliers, but they don’t want to damage the working relationship.
In this case, the customer finds a bank or other financial institution that will offer this service. The two parties agree on terms, then the bank pays the approved invoice amounts to the supplier directly.
Later, the customer will make the invoice payment to the financial institution at the agreed-upon date instead of paying the supplier.
The bank will typically charge interest or other fees for the service, which may be paid by the supplier or the customer, depending on the terms of the agreement.
Reverse factoring vs. invoice factoring
Invoice factoring and reverse factoring have similar outcomes, though the structure and path to get there are distinctly different.
While reverse factoring is initiated by customers who need more time to pay invoices, traditional invoice factoring is initiated by the supplier who needs quicker access to outstanding invoice amounts.
With invoice factoring (sometimes called invoice financing or accounts receivable financing), the supplier sells unpaid customer invoices to a third-party financial institution, less any fees.
There’s very little difference for the customer. Instead of making the payment to the supplier by the due date, they’ll make it to the third party instead.
Reverse factoring vs. traditional financing
Reverse factoring isn’t the only option available to buyers. They may also consider taking out a traditional bank loan to pay suppliers on time, and then make payments to the lender over the repayment period.
Both options require customers to work with a financial institution to negotiate payment terms. However, AP financing is typically better suited for smaller amounts and short-term repayments, while bank loans are ideal for larger amounts and long repayment periods.
Additionally, with a reverse factoring program, the bank directly pays the supplier on the customer’s behalf, taking care of all lingering obligations. On the other hand, a bank loan is dispersed to the customer, and they will be responsible for using the funds to pay the supplier on time. The simplified reverse factoring process may be attractive to customers.
Plus, financing costs may be lower on a reverse factoring program than a traditional bank loan, making it more cost-effective for customers.
How does reverse factoring work?
There are three separate parties involved in reverse factoring:
- The customer: The company that orders the goods/services and needs a way to finance the purchase.
- The supplier: The company that has offered the goods/services and is owed money by the customer.
- The bank or financial institution: The third-party intermediary that has agreed to pay the supplier what they’re owed, which it will later collect from the customer.
Though there are quite a few moving parts involved, reverse factoring is not an overly complicated process.
To understand how this might work in practice, here’s a quick overview of a reverse factoring example:
Step 1: Customer receives and approves a supplier invoice
To start off the process, the customer receives an invoice from its supplier for products or services they ordered.
The customer will review the invoice details, verifying the supplier information, date, quantity, and price before approving it.
Step 2: Customer applies for reverse factoring
Once the customer has approved the invoice, they may determine that they’ll need more time to pay the full amount.
Rather than miss the due date and let the supplier send repeated late payment reminders, it may decide to proactively implement reverse factoring.
In this case, they may start looking for banks and financial institutions that will offer this service.
Step 3: Financial institution and customer negotiate terms
After the buyer finds a lender, the two parties will negotiate the terms and conditions of the financing arrangement.
This includes the interest charges the buyer will owe, any fees the supplier might be able to pay to receive the payment early, the repayment term, etc.
The supplier needs to agree to the arrangement before the funds can actually be released.
Step 4: Financial institution pays the supplier
With all terms finalized, the financial institution will make a lump sum payment to the supplier of the amount that the customer owes them, less any early payment discounts.
Step 5: Customer pays the financial institution
According to the terms of the financing agreement, the customer will make repayments to the financial institution until they’ve fully paid off the invoice amount, plus any interest.
Benefits of reverse factoring
As mentioned above, accounts payable financing offers benefits for all parties involved in the transaction, including the supplier, the customer, and the financial institution acting as the intermediary.
Here’s a closer look at the specific advantages that reverse factoring offers.
Improved cash flow for suppliers and buyers
The main reason why a customer might consider reverse factoring is that it helps support cash flow management for both suppliers and buyers.
With the third-party lender footing the bill temporarily, the supplier gets quick access to the cash they’re owed, supporting their cash flow needs.
At the same time, the customer gets more time to pay the invoice amount, giving them some flexibility in the near term before they owe the payment to the lender.
In the meantime, they can use the cash they do have on hand to cover more critical expenses or higher-interest payment obligations.
Strengthened supplier relationships
Another clear benefit of reverse factoring is that it helps customers protect, and maybe even strengthen, their relationship with suppliers.
If the customer doesn’t have the necessary capital to pay a supplier’s invoice on time, it puts them at risk of harming their reputation with late payments and appearing as a poor business partner.
Instead, reverse factoring not only allows suppliers to be paid on time, but maybe even much ahead of the due date, depending on the financing terms.
It can show suppliers that they’re committed to doing whatever it takes to make timely payments, which can reflect positively on the customer.
Cost-effectiveness for buyers
The repayment terms may allow the customer to make smaller (but more) payments to the lender, in exchange for interest.
The exact interest amount the bank charges can vary. However, this option can be more cost-effective than the late fees imposed by the supplier or the interest on traditional financing methods like loans or credit cards.
Plus, if the customer makes the payment ahead of the due date using reverse factoring, it may qualify them for an early payment discount, offering further savings.
Opportunities to financial institutions
Customers and suppliers aren’t the only ones who benefit from a reverse factoring program.
The bank or financial institution willing to offer this program can earn interest and other financing fees, giving them an additional revenue stream on top of other offerings.
Modernize AP management with BILL
Managing outgoing payments to vendors can be tricky for businesses of all sizes, whether you’re paying their invoices outright or you need to use financing programs, like reverse factoring.
Either way, it’s easier to stay on top of your obligations and gain better visibility into your accounts payable operations with an automated AP solution, like BILL.
BILL helps teams:
- Digitize vendor invoices
- Automate approvals workflows
- Access a wide range of payment options, from ACH transfer to credit card
- Reconcile accounts with automatic 2-way sync
Get started with a risk-free trial of BILL today.
Frequently asked questions
What are common misconceptions about reverse factoring?
Reverse factoring is commonly misunderstood. Some may see it only as a financing option for struggling companies, though this is not the case. Many large companies will use it as a strategy to improve cash flow management and preserve their relationships with suppliers. Additionally, even though it can be more accessible to large businesses with well-established credit and a known reputation, it’s not impossible for smaller businesses to find a bank that will work with them.
What are cost implications of implementing reverse factoring?
Banks and financial institutions do not offer reverse factoring services for free. They typically charge interest or other fees to cover the invoice payment on a customer’s behalf and give a supplier early access to capital. Thus, implementing reverse factoring adds to the total cost of the transaction, either resulting in the supplier receiving less than the total invoice amount or the customer paying the financial institution more than they initially owed.
How to get started with reverse factoring?
Suppliers or companies owed customer invoice payments cannot initiate reverse factoring. The process can only begin with a customer requesting the service from a bank or financial institution. From there, the two parties can negotiate payment terms before the bank pays the supplier.
