The purpose of commercial banking is to help corporations meet their funding needs in a better manner. Commercial banks help companies do this in several ways. One such way is related to the concept of reverse factoring. Reverse factoring is a solution that helps large corporations manage their supply chains better by helping optimize the management of their payables. A large number of corporations have started partnering with their banks in order to take advantage of reverse factoring.
In this article, we will have a closer look at what reverse factoring is and why it is important from the point of view of commercial banking.
What is Reverse Factoring?
The concept of factoring is fairly well known. When a credit transaction occurs between a buyer and a seller, the buyer owes money to the seller. If the seller approaches the banks to sell their receivables in order to obtain money, this is called factoring.
However, when it comes to reverse factoring, the situation is reversed. In this case, it is the buyer who approaches their bank in order to finance their payables. The end result is the same i.e. faster funding from suppliers. However, this approach is buyer-led instead of being led by suppliers. Of course, since banks provide credit, there is an interest charge involved. In most cases since the sellers are receiving early payment, they bear the interest charge. The buyer makes the expected payment to the bank on the expected due date.
Reverse factoring is a viable on-demand alternative to traditional bank financing such as overdrafts.
How does Reverse Factoring Work?
Reverse factoring is a long process that involves multiple steps. The details of some of these steps have been mentioned below:
- The first step is when a buyer creates an agreement between themselves and the bank. The scope of the reverse factoring program viz. the suppliers as well as the invoices covered are clearly listed down. Details regarding fees and payment schedule have to be worked out with the suppliers.
- Once the agreement is in place, the next step is to onboard the suppliers into the process. This may involve sending a communication to the suppliers and also getting them to sign on to a portal that may be created by the bank for this purpose.
- The buyer periodically shares a list of the invoices which are eligible for reverse factoring on such a portal. The presence of an invoice on this list signifies the pre-approval of the buyer.
- In the next step, the supplier can select these invoices from the portal. The bank makes an early payment to the supplier on the next available payment date. The bank deducts an early payment fee from the invoice in order to make up for the short-term loan it has made. The balance money is paid to the supplier.
- Lastly, the payment is made by the buyer to the bank on the scheduled due date. Here bank receives the full amount of the invoice. This essentially means that the bank has pocketed the fee.
Benefits of Reverse Factoring
Reverse factoring is quite popular amongst many corporations because it offers several benefits. The details related to some of these benefits are as follows:
- Lower Financial Costs: It needs to be noted that since reverse factoring is buyer-led, the bank is actually making a loan to the buyer. If the buyer is a large multinational corporation, they have a better credit rating as compared to the seller. Hence, based on their credit ratings, the interest costs become lower for suppliers. This helps the buyer negotiate better payment terms from the seller.
- Predictable Payment Schedule: From the buyers point of view, they can offer their suppliers the flexibility to ask for an early payment without disrupting their own cash flow schedule. The amounts, as well as the dates, remain unchanged for the buyer which gives them the flexibility to better plan their finances.
- On-Demand Financing: From a suppliers point of view, this arrangement is like revolving credit. It is like having a credit card but works out to be much cheaper. They can simply press a few buttons on a portal and the end result is that they get the early payment of an invoice in their account. Also, they can pick and choose the receivables they want to sell based on their cash flow situation at that time. The end result is on-demand financing to the suppliers and that too at a low cost. This makes reverse factoring very popular amongst suppliers.
- No Addition of Debt: Companies all over the world want to show less debt on their balance sheet. This is because more debt on the balance sheet makes credit more expensive. In the case of reverse factoring, no debt is created on the balance sheet of either party. The buyer just pays the regular payables whereas the supplier can get access to early financing for a fee. Neither party has a liability on their balance sheet. This is a very important point for many companies across the world and makes reverse factoring one of the most preferred commercial banking services.
- Better Supply Chain Management: Since the financial needs of both the supplier and the buyer are met without either party having to stretch their finances, commercial banking enables the smooth functioning of the entire supply chain financial system.
To sum it up, commercial banks need the help of technology in order to provide reverse factoring services to their corporate clients. Since this service provides many benefits, it is a much sought-after service in corporate banking.