Factoring and reverse factoring may sound similar, but different parties initiate them. This article throws light on both modes of financing and suggests which one is better for the vendor.
Factoring: Factoring is a financing facility in which a company sells some of its unpaid invoices to the factoring institution. The factoring institution pays 80-90% of the amount immediately, and the rest is paid when the customer makes the payment to the factoring company. The factoring institution deducts its fees while making the final payment.
Reverse factoring: It is a buyer-led financing option wherein the supplier’s invoice is financed by the bank/financial institution at a discounted rate. Here, the supplier gets immediate cash, and the buyer gets more time to pay the invoice. It is an important instrument in supply chain financing as it involves the buyer, the supplier and the financial institution.
In simple words, one can say that factoring is the sale of trade receivables by the supplier to get a loan. It uses trade receivable as collateral for getting loans. But, in reverse factoring, the buyer arranges with the financial institution to make timely payment to its vendor, and the fee is borne by the buyer (usually large retailers).
In reverse factoring, the liability of the lending institution is dependent on the buyer. Let us understand this with the help of the below illustration:
In this process, the lender has only one party to collect the payment from – the buyer. Thus, all the liability and risk is taken by the buyer.
In factoring, the interest cost is borne by the supplier. The funder charges the factoring fee, which usually ranges from 1.15%-4.5%. Also, it issues advance payment at 70%-85%. On the other hand, reverse factoring is a simple setup, and the cost involved for the vendor is low. This is because the funder is taking a risk on the large corporate buyer rather than the small supplier. The suppliers can also receive early payments, which is beneficial for their growth.
As the buyer of goods initiates it, the lending institute’s interest rate depends on the buyer’s credit rating. All parties have clarity about when the payment will be received, so there are no delays or confusion. Thus, we can say that reverse factoring is less expensive than factoring.
Also, when one is dealing in the supply chain, anything can go wrong. So, when opting for reverse factoring, you are paid much earlier than usual. It helps to build a capital reserve which can be helpful for future potential issues in the supply chain.