Reverse factoring: a simple guide for SMBs

Reverse factoring presents an interesting short-term financing option for small businesses. This form of funding lets you pay supplier invoices on time — or early — without eating into your precious cash reserves. 

In many cases, this opens the door to early-payment discounts and an overall healthier cash flow. 

But many business owners either don’t know about or understand this form of financing. This article should clear up any confusion. 

We’ll look at exactly how reverse factoring works, its advantages and disadvantages, and the easiest way to get started. 

Let’s dive in. 

What is reverse factoring? Definition and terms to know

Sometimes known as "supply chain finance", reverse factoring is a short-term financing solution that lets you manage your finances more efficiently. It allows you to pay your suppliers before their invoices are due, so you can keep control of your cash flow and maintain good relations with your partners.

Reverse factoring obviously goes hand in hand with conventional factoring. Let’s unpack both of these terms. 

Factoring 

In a factoring arrangement, receivables are transferred to a financial organisation (the “factor”) in exchange for cash you can use today. Rather than waiting for customers to pay their debts, you get funds up front. The factor then collects payments from your customers, an added benefit for SMBs that don’t have efficient dunning processes.

Factoring can replace or supplement traditional bank loans. Most importantly, it lets you meet your working capital requirements. 

Reverse factoring

Unlike traditional factoring, where the suppliers apply for financing, here it is the purchasing company that initiates the process. You tell the financial institution the amount owed to a supplier, and the factor pays them immediately. You then reimburse the factor (plus fees) at an agreed-upon, later date.

This solution helps you improve cash flow, meet payment deadlines, avoid defaults and, ultimately, maintain healthy supplier relationships. Reverse factoring lets you optimise your cash flow and honour their invoices before their due date, without using up your cash.

For small businesses in particular, this can act as bridging finance during a slow period, where you still have bills to pay but insufficient cash coming in. 

How does reverse factoring work?

Reverse factoring includes three main players:

1. The originator: the company that has to pay the invoices.
2. The supplier: the company that supplied the goods or services and holds the receivables.
3. The factor: the financial institution that advances the funds to pay the invoices.
   

Traditional reverse factoring involves four stages:

1. The supplier sends its invoice to the principal.
2. The client validates the invoice and sends it to the factoring company.
3. The factor pays the supplier promptly, often within 24 hours of delivery or performance.
4. The ordering company reimburses the factor when the invoice is due, in return for a commission at a rate that is generally lower than market interest rates. 

In this configuration, the factor who pays the supplier’s invoices. But there’s also a simpler version of this process which does not involve the supplier directly. Some financial institutions (including Defacto) will pay the funds to you directly, for you pay your invoices with. 

This is less awkward, particularly for small businesses that want to manage their supplier relationships and perhaps don’t want to acknowledge publicly that funds are tight. 

The upshot of both is the same: you have the money you need to pay suppliers on time, without dipping into your savings. 

The advantages of reverse factoring

Often used by large companies with strong credit ratings, reverse factoring is becoming increasingly popular with small and medium-sized businesses. It’s particularly advantageous for companies that manage a large number of suppliers and subcontractors.

Reverse factoring offers a number of advantages for the parties involved:

Improved supplier relations

By paying your suppliers promptly, you ensure the stability of your supply chain. You improve your reputation and increase the loyalty of your wholesalers, subcontractors and other partners.

A solid, optimised relationship with a supplier can also help to boost your operational efficiency and optimise your cashflow management.

And the supplier benefits from getting paid on time, in full. 

Optimised cash flow

Even if your supplier receives immediate payment of their invoice, you retain your original payment terms, i.e. on the due date. You can even negotiate better payment terms with the factor, up to 60 days after the invoice is issued. So you keep your cash for longer. 

This contributes to efficient working capital management, a crucial element for business success, especially during exceptional events such as the Olympic Games.

Reduced payment delays

Rapid payment by the factor reduces delays, making the supply chain more secure. This is a significant advantage when you consider that late payments have a considerable impact on the survival of SMBs, estimated to be worth €12 billion in 2021 in France alone.

This also means a reduction in late payment penalties.

Early payment discounts

Early payment discounts are a type of incentive to pay invoices more quickly. They are often granted in the form of a percentage of the total invoice amount of up to 5%.

This supplier discount helps you cover the factoring company's costs, but can also provide extra cash on top. Used wisely, these are a smart, zero-downside move.

Financial stability for suppliers

As we said, this arrangement enables suppliers to receive their payments well before the due date. This eliminates the waiting periods that could tie up their capital. Suppliers then benefit from smooth cash flow, which reduces their own working capital requirements.

As we know, cash flow is the main cause of failure for very small businesses. So by paying on time, you help ensure that your trusted suppliers will continue to provide the same quality service moving forward.

You may even benefit from kickbacks on the profits generated by the factor on the supplier, depending on the conditions negotiated. In this way, reverse factoring enables you to obtain additional income without affecting your company's cash flow.

Disadvantages of reverse factoring

While reverse factoring has some serious advantages, there are still reasons to move carefully into any contract.

• Cost: There’s no such thing as a free lunch. Unlike traditional factoring, where the cost is borne by the supplier, in reverse factoring it is the ordering company (you) that pays the factor the commission.
• Accessibility: The guarantees required by factors often make this solution inaccessible to SMBs. Some require turnover in excess of €20m, and others insist on huge numbers of receivables. (Defacto is built specifically for SMBs, and doesn’t have these requirements.)

Learn more about reverse factoring

In short, reverse factoring facilitates your invoicing process, resulting in significant gains in operating costs and productivity for your organisation. And while some factors may be slow or difficult to work with, modern, flexible options exist.

With Defacto, you can set up an invoice financing agreement in just 27 seconds (on average). Connect your accounting tools in a few clicks, and you can get an open line of credit based on outstanding receivables, faster than any other lender. 

If optimising working capital and keeping the cash flowing is your aim, there’s really no smarter, simpler way. Get started for free.