Supply chain financing (or reverse factoring) is a form of financial transaction wherein a third party facilitates an exchange by financing the supplier on the customer's behalf. The term also refers to the techniques and practices used by banks and other financial institutions to manage the capital invested into the supply chain and reduce risk for the parties involved.
Unlike traditional factoring (where a supplier wants to finance its receivables), supply chain financing is initiated by the ordering party (the customer) in order to help its suppliers to finance its receivables more easily and at a lower interest rate than what would normally be offered. In 2011, the reverse factoring market was still very small, accounting for less than 3% of the factoring market.
Method
The reverse factoring method, still rare, is similar to the factoring insofar as it involves three actors: the ordering party (customer), the supplier, and the factor. Just as basic factoring, the aim of the process is to finance the supplier's receivables by a financier (the factor), so the supplier can cash in the money for what they sold immediately (minus an interest the factor deducts to finance the advance of money).
Contrary to the basic factoring, the initiative is not from the supplier that would have presented invoices to the factor to be paid earlier. This time, it is the ordering party (customer) that starts the process – usually a large company – choosing invoices that they will allow to be paid earlier by the factor. And then, the supplier will themselves choose which of these invoices he will need to be paid by the factor. It is therefore a collaborative project between the ordering party, the supplier and the factor.
Because it is the ordering party that starts the process, it is their liability that is engaged and therefore the interest applied for the deduction is less than the one the supplier would have been given had they done it on their own. The ordering party will then benefit of a part of the benefit realized by the factor, because they are the one to allow this. And the financier for their part will make their profit and create a durable relation with both the supplier and the ordering party.
Reverse factoring is an effective cash flow optimization tool for companies outsourcing a large volume of services (e.g. clinical research activities by Pharmaceutical companies). The benefit to both parties is that the company providing the services can get the outstanding value of their invoices paid in 10 days or less vs. the normal 30- to 45-day payment terms while the ordering party can delay the actual payment of the invoices (which are paid to the bank) by 120–180 days thus increasing cash flow. After the initial period of cash flow optimization, it is unclear if this will remain of value to the ordering party because you will then be paying monthly invoices of approximately equal amounts assuming your outsourced services are stable/average across the year/future periods. The cost of the "money" is a set interest rate normally tied to an index plus a bps adjustment.
The concept
To fully understand how the reverse factoring process works, one needs to be familiar with trade discounts and factoring. Indeed, reverse factoring could be considered as a combination of these two methods, taking advantages of both in order to redistribute the benefits to all three actors. In order to better understand the process, it is necessary to look at the 8 individual aspects of those three financing methods:
Historic
The concept of reverse factoring started with automobile constructors - including Fiat in the 1980s - who used this kind of financing process for its suppliers in order to realise a better margin. The principle then spread to the retail industry because of the interest it represents for a sector where payment delays are at the heart of every negotiation.
In the 1990s and the early 2000s, reverse factoring was not used extensively due to economic contexts that did not allow it to be an efficient way of financing.
