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How To Set Reasonable Payment Terms

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Posted by Brett Romero - 28 August, 2019

A Beginners Guide To Reverse Factoring

Reverse factoring may sound like (invoice) factoring, but the two are very different. Reverse factoring works by financing invoices for suppliers. This is downstream financing rather than upstream (financing customer invoices), as is done in factoring. For this reason, reverse factoring is also called supply chain factoring.

Quick Review of Invoice Factoring

Before diving into reverse factoring, lets first do a quick review of how invoice factoring works. Invoice factoring is what most of us think of when we hear factoring. Invoice factoring is an accounts receivable solution.

When a company needs cash, it can receive an advance on its invoice by using a factor. The factor advances a percentage of the invoices' value. This might be 80 to 90 percent. Once the factor receives payment on the approved invoices, it will advance the remaining percentage minus a fee. This fee can be between 1 to 4 percent of the overall value of the invoices.

Companies that want to factor their invoices must meet specific criteria, which varies across factors. Generally, the criteria include a certain monthly amount of revenue, creditworthiness of customers, the business must be B2B or B2G, and have a certain monthly dollar amount of invoices.

The benefit of factoring is cash flow (the advance received by the factoring company). Now let's see how reverse factoring works.

How Reverse Factoring Works

Reverse factoring, also called supply chain finance, works in the opposite direction of invoice factoring. Instead of a company factoring customer invoices, it factors supplier invoices. In doing so, the company is factoring part of the supply chain. Reverse factoring is an accounts payable solution.

To better understand how the reverse factoring process works, let's look at an example workflow. Below the "buyer" is the company that initiates reverse factoring. They are the buyer of supplier products. Generally, this is the manufacturer but not always.

  1. The buyer is trying to extend terms with suppliers, so the suppliers are paid later. Extending terms is not something suppliers have an incentive to do.
  2. The buyer finds a bank or financing company for the supplier invoices.
  3. The bank offers to finance the receivables of several suppliers.
  4. The suppliers agree to the financing.
  5. Suppliers deliver goods or services and invoice the debtor (buyer).
  6. Supplier invoices are sent to the bank.
  7. The buyer approves invoices to be financed.
  8. At some later time, the buyer pays the invoices. Payment goes to the bank.

Let's look a little deeper at this process. In step three, suppliers agree to financing because they are getting paid in 10 days rather than 60, for example. Certainly, a 50 days advance for a small fee is worth the price.

One questions to ask is: Why would a supplier agree to financing? It's the buyer who initiated reverse factoring after all. The supplier doesn't need financing. But if the supplier doesn't agree, then the buyer is out of luck for the most part.

The main reason the supplier agrees to financing is that they get paid much sooner. For this early payment, there is a small fee involved. For the buyer, their fee comes in the form of an interest rate.

Reverse factoring doesn't always mean that the manufacturer is the one in need of cash or working capital. The supplier may be the one in a cash flow crunch and in need of a cash injection. Isn't that the supplier's problem? Yes, but it also affects everyone further up in the supply chain. If the supplier's problem is not solved, everyone suffers. It's worth it to the manufacturer to resolve the supplier's issue and get the supply chain moving again.

cash flow(source)

Who Does Reverse Factoring Mainly Benefit?

Reverse factoring benefits everyone in the supplier chain. You could even say customers benefit since their products will be delivered. We hinted on this in the last paragraph above but let's now expand on it.

If one supplier in the supply chain cannot buy raw materials and holds up the flow of products, the problems ripples through the supply chain. Resolving this one supplier's issue unclogs the supply chain and allows products to continue being manufactured and (hopefully) delivered on schedule.

Basically, if someone in the supply chain has a finance issue and can't pay their invoices, this can quickly become a problem for everyone in the supply chain.

Additionally, suppliers get more frequent cash flow at a cost (i.e., financing fee) that is much lower than financing in the open market based on their credit rating. These financing terms are too good to turn down. They are certainly better than the terms offered by the manufacturer (60-day net terms).

longer payment terms

There are many benefits to reverse factoring. The main benefit is the continued smooth operations of the supply chain. Reverse factoring doesn't always start with the manufacturer. It can be anyone in the supply chain. A supplier that has more suppliers under it may decide to use reverse factoring to help a supplier in need to ensure the supply chain isn't jeopardized.

Summary

  • Invoice factoring allows you the opportunity to get paid faster
  • The supplier has to pay a small fee for getting the early payment
  • Reverse factoring benefits everyone in the supplier chain
  • Reverse factoring can look different for every business, and can be utilized based on the needs of your company

Net terms accounts receivable

Topics: Finance, Factoring, invoice

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