Invoice Factoring vs Reverse Factoring: Which is Best for Your Business?
When you’re looking for ways to fund your business, you’ve got to look at every possibility to find the right fit and create your ideal funding mix. Maybe you’ve decided that getting your invoices paid in advance makes sense and you’re researching all the possible ways it can be done. As entrepreneurs ourselves, we understand wanting to know you’ve made a smart choice for your business. We’ll explain everything you need to know about invoice factoring vs reverse factoring, including how they stack up, and how to pick the best financing option for getting the working capital your business needs.
What Is Invoice Factoring?
Invoice factoring is a type of financing where a business sells its unpaid invoices to a third-party for immediate access to cash. You receive a cash injection for the invoice amount, usually less any fees, ahead of the payment terms. Your customer, who is responsible for paying the invoice, instead pays the invoice amount to the financing company according to the original payment terms. Traditional invoice factoring is a convenient way for businesses to improve their cash flow situation and manage their working capital, without taking on additional debt. Invoice factoring also goes by the terms accounts receivable financing or invoice financing.
What Is Reverse Factoring?
The reverse factoring process is quite similar to classic factoring. The main difference with reverse factoring vs invoice factoring is that with reverse factoring, the buyer has set up a program with a factoring company, bank, or other financing partner. With invoice factoring, you have your own factoring partnership in place.
How Does Reverse Factoring Work?
With reverse factoring, the supplier invoices for the completed work. The buyer then accepts the invoice, before sending it to whoever is providing the reverse factoring solution. This often all take place through an online portal or via some other electronic means. The supplier can opt in to getting the invoice paid quickly, or take no action and get paid according to your normal payment terms. If the supplier opts in, the factoring company keeps their discount rate, pays the supplier the remaining part of the invoice, and waits to get paid by the buyer on net terms, just like in invoice factoring.
Reverse Factoring Example
It’s often helpful to see a practical example of how to reverse factor to better understand the process. Let’s take a look at the following example:
You’re a steel supplier for a warehouse dock manufacturer. You supply them with $100K in steel, sending an invoice for the raw materials. The dock manufacturer has a relationship in place with a financial institution that offers reverse factoring. They approve your invoice and send it along to the factoring company, giving you the option to fund the invoice ahead of the extended payment terms. Your next big order comes in and you find yourself in a cash flow crunch. Instead of waiting 90 days to get paid, you choose to fund the invoice and receive $96,000 in just a few days, minus the financing rate of 4%. The dock manufacturer then pays the factoring company according to the agreed-upon payment terms.
Benefits of Reverse Factoring
The benefits of reverse factoring are similar to the benefits of factoring with a few key differences. The ones that are specific to reverse factoring and not shared with invoice factoring are completely bolded.
- Quick access to working capital. Reverse factoring can help improve cash flow for both buyers and suppliers. Benefits for suppliers include receiving early payment for invoices, while buyers can extend payment terms without negatively impacting the supplier’s cash flow.
- Flexibility & convenience. Another benefit of factoring is that many companies offer an easy experience (especially with the use of technology), but with reverse factoring it can be even easier since you can skip some steps in the funding process (see below). However, many companies with reverse factoring won’t let you use a different factoring company for their invoices.
- No long-term commitment after invoice is paid. When it comes to factoring vs reverse factoring, both require no long-term commitment once the outstanding invoice is paid. Simply fund the invoices you want, when you want.
- No admin cost and time spent chasing accounts receivable. Both invoice factoring and reverse factoring can help streamline invoicing and payment processes for both buyers and suppliers. Suppliers can submit invoices directly to the factor for payment, which can reduce the administrative burden on the buyer’s accounts payable department.
- Approval doesn’t depend on your credit, but your customer’s credit. Since your customer is the one responsible for paying the invoice and is the credit risk, you can still qualify even if your credit rating or credit profile is less than stellar.
- No need to worry about customer relationships. Some business owners worry what their customers will think about them using invoice factoring – that they’re financially weak or can’t serve clients. On top of that, some factors in the past have damaged customer relationships because they hounded customers for payment. However, there’s no risk of this with reverse factoring. You don’t have to worry about this with a reverse factoring arrangement.
- No need for supplier to communicate with their customer to get an NOA signed (buyer still needs to officially accept invoices and verify that work has been completed.)
Drawbacks of Reverse Factoring
The drawbacks of reverse factoring are similar to the negatives of invoice factoring with a few key differences. The ones that are specific to reverse factoring and not shared with invoice factoring are bolded.
- Difficult to account for in bookkeeping. Many people think that recording factoring transactions in their accounting software is confusing or difficult. Our step by step guide walks you through the process.
- Can only get invoice payments from that one customer this way. If you want to fund invoices from another customer, you’ll have to get set up with a separate factoring service. This means spending more of your valuable time on administrative tasks.
- No option to choose your own factoring company for invoices from this particular customer. Without the ability to choose your own factoring company, you give up a lot of control in the factoring relationship. You could be subject to hidden fees or a lack dedicated customer support. When you can’t choose a financing partner based on the criteria that works for you – such as speed, ease of setup and funding, with a company whose tech supports it – you could be dealing with a less than optimal arrangement. It might not matter much if you do infrequent work for this customer or the invoices are small. The convenience could be worth it. But if you’re dealing with large, frequent invoices and the terms aren’t favorable or the service is bad, it could make a big difference. The financial institution chosen by the buyer might treat suppliers as a lower priority compared to the buyer. With a dedicated factoring company, the supplier is the customer and gets priority.
Invoice Factoring vs Reverse Factoring: What's the Difference?
To sum up the differences:
- The process. With invoice factoring, you have to send customers a Notice of Assignment (NOA) to sign. With reverse factoring, this step isn’t necessary because of the existing partnership with the financial institution.
- Customer relationship concerns. With invoice factoring, you may have concerns about how a factoring company will treat your customer. With reverse factoring, there are no concerns about this, but it only applies for that one buyer.
- Degree of choice for supplier. With reverse factoring, you have to accept the advance rate, discount rate, customer service, etc. that come with the buyer’s finance company. With invoice factoring you can find the financing partner that makes sense for your business, and can fund invoices from your other customers as well.
How Do I Choose Between Factoring vs Reverse Factoring?
We can’t tell you what to do, since only you know the particulars around your business and customer relationships. But here’s what we recommend you consider when deciding if invoice factoring is worth it, or if reverse factoring would better suit your situation:
- If your customer even has a reverse factoring program. If your buyer doesn’t offer this, you have your answer.
- If your invoices to this customer are large and/or frequent. The more you’d use the program, the more it matters what the supplier payment terms are.
- Convenience vs costs. If the reverse factor terms are favorable and the finance company’s policies work for you in addition to the extra convenience, working with them definitely makes sense. However, if you’re only using the program because it’s easy – and because for some reverse factoring programs you won’t be allowed to use your own factoring company for this customer’s invoices – but the discount rate and hidden finance fees are adding up, reconsider the value you’re getting
- The terms of your customer’s financing partner. Ask about their:
- Advance rate – This is the amount of the submitted invoice the financing partner pays you right away. Some will only advance 80% now and 20% once your customer pays. Others will pay 90% or more. (While FundThrough is an independent factoring company, we pay 100% advance rates.)
- Discount rate – Also known as the factoring fee or financing fee, the typical factoring rate is between 1% and 6%. Compare our pricing to other factoring companies before signing a factoring contract.
- Hidden fees – Just because a factoring company offers a low discount rate, doesn’t mean that’s the whole story. They could be hiding hidden fees such as a convenience fee or financing fee. Make sure you know about them before signing a reverse factoring agreement.
- Customer service – Are you getting the support you need? Are your fundings coming through without issue? If not, you might want to look into another alternative financing method.
Is reverse factoring debt?
No, reverse factoring is not debt because the customer pays the invoice. You don’t have to pay back a borrowed balance so there’s no debt added to your balance sheet.
Who uses reverse factoring?
Reverse factoring is used by a wide range of companies in various industries, particularly those with complex supply chains and numerous suppliers. Large corporations, such as retail chains, automotive manufacturers, and apparel companies, are among the most common users of reverse factoring. Ultimately, anyone involved in a supply chain can potentially use reverse factoring as a financing solution.
What is supply chain finance?
Supply chain finance is just another name for reverse factoring. It also goes by supply chain factoring, supplier finance, or supply chain financing.
How does supply chain finance work?
Since it’s another name for reverse factoring, the steps are the same.