Social:Reverse factoring

Unlike traditional factoring, where a supplier wants to finance its receivables, reverse factoring (or supply chain financing) is a financing solution initiated by the ordering party (the customer) in order to help its suppliers to finance its receivables more easily and at a lower interest rate than what would normally be offered. In 2011, the reverse factoring market was still very small, accounting for less than 3% of the factoring market.

A financing solution

The reverse factoring method, still rare, is similar to the factoring insofar as it involves three actors: the ordering party (customer), the supplier, and the factor. Just as basic factoring, the aim of the process is to finance the supplier's receivables by a financier (the factor), so the supplier can cash in the money for what they sold immediately (minus an interest the factor deducts to finance the advance of money).

Contrary to the basic factoring, the initiative is not from the supplier that would have presented invoices to the factor to be paid earlier. This time, it is the ordering party (customer) that starts the process – usually a large company – choosing invoices that they will allow to be paid earlier by the factor. And then, the supplier will themselves choose which of these invoices he will need to be paid by the factor. It is therefore a collaborative project between the ordering party, the supplier and the factor.

Because it is the ordering party that starts the process, it is their liability that is engaged and therefore the interest applied for the deduction is less than the one the supplier would have been given had they done it on their own. The ordering party will then benefit of a part of the benefit realized by the factor, because they are the one to allow this. And the financier for their part will make their profit and create a durable relation with both the supplier and the ordering party.

Reverse factoring definition

An alternative financing solution where a supplier finances their receivables via a process started by the ordering party, in order to help their suppliers receive more favorable financial terms than they would have otherwise received for operational and other pass-thru costs incurred in providing services to the ordering party.

Reverse factoring is seen as an effective cash flow optimization tool for companies outsourcing large volume of services (e.g. clinical research activities by Pharmaceutical companies). The benefit to both parties is that the company providing the services can get the outstanding value of their invoices paid in 10 days or less vs. the normal 30- to 45-day payment terms while the ordering party can delay the actual payment of the invoices (which are paid to the bank) by 120–180 days thus increasing cash flow. After the initial period of cash flow optimization, it is unclear if this will remain of value to the ordering party because you will then be paying monthly invoices of approximately equal amounts assuming your outsourced services are stable/average across the year/future periods. The cost of the "money" is a set interest rate normally tied to an index plus a bps adjustment.

The concept

To fully understand how the reverse factoring process works, one needs to be familiar with trade discounts and factoring. Indeed, reverse factoring could be considered as a combination of these two solutions, taking advantages of both in order to redistribute the benefits to all three actors. In order to better understand the process, it is necessary to look at the 8 individual aspects of those three solutions:

	trade discount	factoring	reverse factoring
Eligibility	all invoices	all invoices	validated invoices
Financement	at the ordering party initiative	at the supplier's initiative	at the ordering party initiative
Sum financed	100% of the invoice (-discount)	part of the invoice	part of the invoice
Interest rate	depends on the supplier's situation	depends on the supplier's situation	depends on the ordering party's situation
Payment	immediate	due date	due date
Impact on the Need Working Cash	negative	none	none
Financial interests	value of the discount (but involves cash outflow)	none	percentage of the discount
Deployment to other suppliers	slow (adaptation to each supplier)	none	fast

Historic

The concept itself of the reverse factoring is not that original. It is the automobile constructors who started to use it. Particularly, Fiat, as of the 1980s’, used this kind of financing process for its suppliers in order to realise a better margin. The principle then spread to the retail industry because of the interest it represents for a sector where payment delays are at the heart of every negotiation.

In the 1990s’, and the early 2000s’, the reverse factoring was not used a lot because of the economic contexts that did not allow it to be an efficient way of financing. Today however, because of the NTICs and various legal advances, it has become a very successful tool.

An improvement of business relations

In the basic invoicing or factoring framework, there are always some risks that threaten the invoices:

• inaccurate invoice (fraudulent, erroneous calculation, or typographical error)
• an underestimated time of payment delay
• an incorrect estimation on the object of the invoice (a service poorly executed)
• etc.

By using the reverse factoring, these risks are materially reduced.

Advantages

For the supplier

The supplier has its invoices paid earlier; therefore it can more easily manage its cashflow, and reduce by the way the costs of receivables management. Moreover, as it is the ordering party that puts its liability at stake, it benefits from a better interest rate on the trade discount than the one that would have been obtained by going directly to a factoring company. The reverse factoring is very useful for small companies that have large groups for clients, because it creates a more durable business relation as the big company helps the smaller one, and doing so gets some extra money. This opinion does not account for the poor relations caused by unilateral changes to credit terms. Smaller companies are generally not given a choice to accept the additional cost of finance imposed by this process. In a factoring process, if there is any problem concerning the payment of the invoice, it is the supplier that is liable, and has to give back the money he received. In the reverse factoring process, as it concerns validated invoices, as soon as the supplier receives the payment from the factor, the company is protected. The factor will have to get its money from the ordering party. Finally, in a trade discount system, the supplier is forced to be paid cash, regardless of its cash flow. Some reverse factoring platforms identified this problem, and therefore propose to the suppliers a more collaborative solution: they choose themselves the invoices they want to receive cash, the others will be paid at due date.

For the ordering party (the buyer)

The reverse factoring permits all the suppliers to be gathered in one financier, and that way to pay one company instead of many, which eases the invoicing management. The relation with the suppliers benefiting of the reverse factoring is improved because they benefit from a better financing solution, and their payment delays are reduced; for its part, the ordering party will gain some extra money reversed by the factor and pay her invoices to the due date. Making suppliers benefit from such advantages can be a powerful leverage in negotiation, and also ensure a more durable relationship with the suppliers. Moreover, it ensures that the suppliers will be able to find advantaging financing in case of cash flow problem: using reverse factoring assures that the suppliers will still be in business, and are reliable. With the reverse factoring, instead of paying numerous suppliers, most of the invoices are centralized with the same factor; it is always better for the accounts department to deal with one company to pay than several. This can also be simplified and speeded by using a reverse factoring platform combined with digitalization of business transactions (i.e. EDI).

For the factor (the financier)

By taking part in the reverse factoring process, the factor realizes a benefit by making available cash to the supplier and supporting in its place the delays of payment. However, in opposition to the factoring, in this situation the factor is in a more durable business relation as everyone benefits from it. Other advantage for the financier, is that he works directly with big ordering parties; it means that instead of going after each and every supplier of that company, he can reach faster and more easily all of the suppliers and do business with them. Therefore, the risk is less important: it passes from a lot of fragmented risks to one unique and less important.

Optimization of the process

Often the reverse factoring is used with the dematerialization to speed the process. As the whole goal of it is to make money available to the supplier as fast as possible, a lot of companies decide to dematerialize their invoices when they start a reverse factoring system, because that way it saves few more days, plus all the advantages of the dematerialization (less expensive, and benefic to the environment). In average, it can shorten the delays by 10 to 15 days.

Choosing the right reverse factoring solution

The core principle of the reverse factoring is to have a way that benefits to all the actors. That way, it is necessary to have good relations with the other actors. The principal risk in reverse factoring is that the supplier gets trapped in a system where he cannot decide which invoices he need paid immediately or not, and therefore he becomes the victim of that system. Therefore, it is necessary to choose a collaborative platform that would permit the supplier to select which invoices they will be paid early, and when they will be paid.

References

[1] Supply Chain Finance- a strategic view article by Igor Zax in Supply Chain Yearbook 2011/2012

See also

• Factoring
• Paperless office
• Supply chain engineering