Unleashing the Power of Reverse Factoring : Transforming Supply Chain Financing

Muhammed Thabsheer TK
Business Analyst

10-Feb-2023

Reverse Factoring

In many industries cash flow is important to keep this interconnected web running smoothly, since all the participants rely on each other's healthy cash flow. Reverse factoring emerged out of this cash-flow interdependency. Reverse factoring, also known as supply chain financing accelerates payments and optimize working capital.

Reverse factoring refers to a concept when a company, the buyer reaches out to a financial institution to pay its suppliers at a faster rate, thereby reducing the account Payable time for them, the buyer and the account receivables time for the suppliers. This allows the company to avoid a credit crunch and still get the supplies it needs. which in turn will charge an interest and will be paying out to the factor, the financial institution at the end of predefined time duration. The interest rate is usually based on the creditworthiness of the company, the length of time it takes for payment, and the amount of the invoice.

How Does Reverse Factoring Work?

Traditional Factoring Vs. Reverse Factoring

Reverse factoring is different from traditional factoring. Traditional factoring is a financial transaction in which a company sells its accounts receivable (i.e., invoices) at a discount to a third party called a factor. The factor pays the company the full-face value of the invoices, less a discount. The discount rate is usually based on the creditworthiness of the customer, the length of time it takes for payment, and the amount of the invoice. This type of financing is used by companies to obtain short-term working capital

Advantages of Reverse Factoring:

• Payments to suppliers are expedited, resulting in fewer delays in payment for goods and services. This leads to improved cash flow, which can improve the company's overall profitability.
• As a result of invoices being paid promptly, suppliers no longer need to pressurize firms for early payment. This allows both sides to focus on their respective duties and leading to improved management and resource utilization.
• Reverse factoring is a type of agreement between a financial institution and a firm, not the firm's suppliers. The terms and interest rates are based on the firm's creditworthiness, so the suppliers are not affected.
• Reverse factoring is a way of making the balance sheet look more attractive by improving ratios such as working capital turnover and trade payable turnover, without having to show the transaction on the balance sheet. This keeps both investors and shareholders content.

Disadvantages of Reverse Factoring

• The success of reverse factoring depends largely on the ability to forecast sales and that the buyer/organization is able to repay the invoice amount to the factor, financial institution with a pre-agreed interest rate after a certain period. If this does not occur, the financial institution could suffer a loss, leading to a credit crunch for the organization due to regulatory scrutiny. This could then potentially cause a more significant problem as the firm could find itself without necessary funds when it needs them most.
• If not organized competently, it can be very costly for the company since it might necessitate intricate agreements and ambiguous regulations.

Conclusion

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.

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