Supplier financing or reverse factoring is a set of business finance solutions that allow businesses to extend their payment terms to their suppliers with the aim to lower business costs. In an increasingly integrated global marketplace, small suppliers are competing for more than ever with their bigger counterparts to do business.
Like most small businesses, small suppliers can find it hard to raise working capital. Many lack the necessary collateral to take out banking loans or have bad credit scores, rendering them a liability for potential lenders.
Others don’t possess adequate working capital to secure even short-term credit. The lack of financial buffers means that suppliers aim to be paid as soon as an order is fulfilled, while buyers do their best to postpone payment. The supplier is left tussling with the buyer, and every business transaction runs the risk of turning into a wrestling match.
This is where supplier financing, also known as supply-side financing or reverse factor financing, comes into play. Its signal innovation is what might be called ‘supply chain collaboration’, where key stakeholders work together to settle their accounts with each other.
What is supplier financing
Supplier financing is a payment solution that buoys small suppliers and buyers (of all sizes) alike. What is unique about this model is that the supplier is reimbursed as soon as they raise an invoice for the sale of receivables.
The question of loans and credit no longer figures in the equation on the supplier’s side. It benefits buyers as well, as it shores up their reputations as reliable partners to do business with. Reverse factoring extends the terms of their accounts payable while allowing them to fulfill their financial obligations to their suppliers. In other words, they make the payment but not with their own money. So whose money is it then?
How does supplier financing work
Supplier financing is a benign version of the ‘robbing Peter to pay Paul’ scenario. Typically how it works is that the buyer pays the supplier (‘Paul’), with money that she gets from her company’s financial institution (‘Peter’). This is because the buyer has sufficiently good credit/collateral to be eligible for a short-term loan of this kind. In return for timely payment of dues, the supplier is charged a small fee, which goes to the company’s bank. So the benefits of this solution and their distribution are as follows:
Benefit 1: The seller is paid early, well within the stipulated 30-day payment period, without having to worry about securing credit.
Benefit 2: The buyer doesn’t have to cough up the cash immediately, and gives them a breather should cash flow below.
Benefit 3: The financial institution that is fronting these funds makes some money off this transaction.
Alternatives to banking institutions
There are various services that pose alternatives to the one-on-one arrangement between buyers and their banks. Some of them function as facilitators. Services that offer supplier financing provide buyers with a variety of options:
- To apply to a network of financial institutions accessible to the facilitator.
- To use their own funds.
- To combine multiple financial sources: including the buyer, banks, and capital markets.
Supplier financing has proven to be a very popular financial arrangement, particularly among SMBs (for obvious reasons). Small and medium enterprises, both buyers and sellers, would do well to consider adopting this approach in their business dealings.