Reverse factoring is a buyer-initiated supply chain financing mechanism for prompt payments to suppliers based on validated invoices. A supplier delivers goods or services to the buyer and issues an invoice. The buyer approves the invoice, which is purchased by a financier or lender at a pre-agreed discount. The buyer is then required to repay the financier on or before the invoice’s due date. This contrasts with traditional factoring, in which a company sells its receivables to a financier at a discount and the company’s customers pay the financier directly.
Reverse factoring is an efficient solution, solving the problems of suppliers and buyers, and offering significant benefits to each party. It enables the supplier to offer extended payment terms to the buyer while securing prompt payment from the financier. This improves its cash flow without having to wait for the buyer’s direct payment. The financier usually relies on the buyer’s creditworthiness and commitment to pay the financier directly on the invoice due date. This is because the buyer is often a larger, more creditworthy entity than the supplier. Consequently, the interest rate charged by the financial institution is based on the buyer’s credit rating, not the supplier’s. This usually results in a lower cost of funding than the supplier could otherwise achieve.
Buyers benefit by receiving the goods or services immediately, reducing the risk of disruption in their supply chains and managing their liquidity more effectively. This is because they can postpone payment until the invoice’s due date. Because the buyer arranges the financing, it may be able to negotiate more favourable terms with its suppliers. The advantage to the financier is the profit from the difference between the discounted invoice purchase price and the payment from the buyer. The financier also gains a valuable database of suppliers, creating opportunities for cross-selling financial products and services.
In such a transaction, it is essential to draft the agreement between the financier and the buyer with precision. The agreement must set out the responsibilities of the buyer, such as giving detailed supplier information, depositing the full invoice amount into the financier’s account, and, if contractually agreed, offering a programme-level guarantee. If a guarantee from the buyer is required, the buyer and the financier should enter into a separate deed of guarantee.
The financier and the supplier must also conclude a separate loan agreement. This should specify that the supplier will deliver goods or services to the buyer and issue an invoice detailing the date, description, and amount due. On the buyer’s acceptance of the invoice, the financier may give the supplier a loan, with the buyer making the repayments. The financier should insist that the supplier hypothecates the amounts payable by the buyer under the accepted invoice, as a security for the repayment of such a loan. Such hypothecation should either be created by the execution of a loan cum hypothecation agreement, or by the execution of a separate deed of hypothecation. The loan agreement may stipulate that if the buyer fails to repay the loan obligations, the supplier shall do so and in such an event, the financier should therefore require the supplier to provide post-dated cheques. The security is thus structured in a way that mitigates the financier’s risk.
Eligible financiers, that is all banks and non-banking financial companies granted certificates of registration from the RBI to carry on business under the Factoring Regulation Act, 2011, may participate in reverse factoring and factoring transactions involving MSMEs. This is through the Trade Receivables Electronic Discounting System platform, authorised by the RBI to facilitate the financing of trade receivables.
Reverse factoring strengthens buyer-supplier relationships, optimises cash flow, and enhances supplier financial stability. It provides businesses with greater financial flexibility and operational efficiency. Increasing recognition of its benefits is driving industry stakeholders to enhance supply chain finance solutions. Financial institutions are improving their processes by embracing digital platforms and fintech innovations, and integrating advanced technologies. In this evolving landscape, it is crucial that all parties meticulously and precisely draft their obligations and benefits.
– The authors of this article are Sharad Joshi, Partner, and Rachit Verma, Senior Associate at SNG & Partners.
