What’s The Difference Between Factoring and Reverse Factoring?
No matter what type of business you’re running, there are often multiple financing options that you can consider to get capital for your business relatively quickly and get your cash flow back in great standing.
Factoring and reverse factoring are both options that businesses take advantage of for this exact purpose. Factoring and reverse factoring allow businesses to receive necessary funding relatively quickly, though they’re used in very different ways.
So what’s the difference between factoring and reverse factoring? In this post, we’ll take a look at both options, when to use them, and how to decide what’s right for your business.
What’s Factoring?
It only makes sense to start by diving into factoring before we look at its reverse counterpart.
Factoring is also commonly referred to as known as “invoice financing”. Factoring is a relatively straightforward financial transaction in which a business submits its unpaid customer invoices to a third-party company, which will pay around 80% of the invoice’s totals. Your customer will pay the third-party company, at which point they’ll remit the rest of the payment, minus any agreed-upon fees.
In most cases, businesses can opt to finance all of their invoices, or only select invoices for their choosing. This gives them control over how and when to utilize factoring for their benefit.
It’s common for businesses to have contracts with customers requiring they pay within thirty, sixty, or ninety-day periods, or perhaps even longer if they’re on extended payment plans. Waiting for those ninety days to receive payment, however, can be difficult when you’re trying to stay on top of cash flow. The ability to receive early payment (even if not totally in full) frees up a lot of working capital to keep operations running as usual in the meantime.
What Is Reverse Factoring?
Reverse factoring is also called “supply chain financing.” It’s a type of financing in which a bank or third-party lender will pay a company’s invoices for them in advance in exchange for a discount.
Instead of having the third-party finance the invoices to speed up the process of receiving a payment like typical factoring, here the ordering party uses funding from the supplier to finance their receivables in advance. The buyer will then pay the lender at an agreed-upon later date.
Here’s how it works. Imagine that you are a laptop manufacturer, and you’re sourcing multiple parts from different suppliers. You get the case from China, the screen from Italy, and the hard drive from Silicon Valley in California. After each piece is individually produced, it’s all shipped to you in Massachusetts for everything to be assembled, packaged, and mailed off to the distributor.
If however, the supplier in Italy hits a snag with cash flow and is struggling to afford to continue with screen product, it can bring your entire operation to a grinding halt. In this case, they could submit their invoice to you to the third-party lender. The third party grants them the capital needed to complete the task, and the company in Italy just has to pay a small fee. The supply chain overall keeps moving, allowing you to put together those computers on top and sending them out as promised.
So What Exactly is the Difference?
Factoring and reverse factoring can sound similar. Both allow businesses to receive payments in advance to keep their cash flow moving and their operations proceeding as expected. There are, however, a few key differences.
The first major difference is the timing.
If we’re using the same example that we discussed above, you as the laptop manufacturer could use invoice factoring after you bill the distributor. The product has already been delivered, and you’re just waiting on the invoice to be paid.
Meanwhile, with reverse factoring, any of the suppliers who need to get parts to you (like Italy and their screens) could use reverse factoring in order to gain the capital needed to continue their operations and deliver their expected supply. Instead of the financing going to a single manufacturer, it’s going to suppliers so they can keep their supply chain moving.
Which is Right for My Business?
When deciding whether you should look into factoring or reverse factoring, the biggest factor to focus on is where you are in the supply chain. Are you looking to gain working capital by receiving payment for invoices that have already been sent, or to receive advance payments that you need in order to deliver your promised products to the next person in the supply chain?
When you’re applying for both factoring and reverse factoring, it’s important to keep in mind that the third-party bank or financing company will want to assess their financial risk in offering you advanced payments. They’ll likely ask for the following when reviewing your initial application:
- Current profit and loss statements
- Business credit history
- Credit history of the customers you’ve sent the invoices to
- Financial forecasts
- Information on your current working capital
- Financial forecasts and financial statements, which may include recent tax returns
Final Thoughts
There are plenty of financing options available for many businesses to choose from, and factoring and reverse factoring are two excellent alternatives to traditional loans.
Both allow you to receive upfront, non-debt financing that comes with lower fees than most loans, especially considering there aren’t high-cost interest rates. Once set up with a lender, they’re also typically quick and can potentially distribute payment within a few days. And, unlike loans which distribute lump-sum payments only once, you can utilize factoring and reverse factoring as you see fit to keep your cash flow in good condition.
Interested in learning more about factoring, or its preferred option, invoice financing, and supply chain financing? See how we can help you here.