Supply Chain Finance and Reverse Factoring
All supply chain professionals should understand not only the physical flow of goods and services towards the end-customer, but also the financial flow of money from the customer back up the value chain.
Consider this scenario: How does a large firm, let alone a small business, increase its supply chain capacity to better serve its customers? CAPEX investments in new manufacturing plants, logistics fleet, or enterprise technologies are costly upgrades. If a firm does not have sufficient cash to pay for these upgrades due to outstanding account receivables, one trending financial recourse — exacerbated by the pandemic no doubt — is to increase assets through supply chain financing.
In simple terms, supply chain finance (SCF) refers to an agreement between buyer and seller to restructure the financing of purchases in order to generate working capital that benefits both parties. A financial institution, such as a bank or fintech partner, effects this model.
There are eight models of supply chain financing as listed in Table 1. In the next section, I deep dive the one of the most popular methods: reverse factoring, also referred to as payables finance.
Reverse Factoring
Unlike traditional factoring where a financial institution purchases receivables from a seller at a discount, in reverse factoring, the supplier sells their receivables to a financial institution which agrees to finance these sellers based on the credit risk of the buyer. At maturity, the buyer pays the principal amount owed to the financial institution.
To illustrate this process, imagine a scenario where a farmer (supplier) sells crops to a grocer (buyer), as depicted in Figure 1. Reverse factoring typically follows these steps:
The grocer places an order to purchase $1MM worth of crops from the farmer.
The farmer delivers on this order and transfers its accounts receivables (i.e. invoice) to the grocer.
The grocer approves the invoice and shares it with the financial institution (e.g. a bank).
The farmer sells the invoice to the bank.
The farmer receives payment from the bank for a discount off the invoice or chooses to defer payment for a smaller or no discount.
The grocer settles the account with the bank based on its credit-worthiness and on a predetermined schedule.
As such, if the farmer needs cash immediately, it can use reverse factoring to receive payment from the bank less the 1% discount, meaning it will receive $990,000 and the bank retains $10,000. If the farmer is not on a cash crunch, it can defer payment and receive the full $1MM at a later date. Separately, the grocer pays the invoice to the bank on a schedule better aligned with its cash flow, plus fees and interest associated with its credit-worthiness.
Summary
Supply chain financing (SCF) is a form of short-term borrowing to generate working capital. In a standard model, buyers receive payment extensions from a financial institution to improve its working capital and sellers get paid earlier than they would have otherwise. Financial institutions provide this service through fee-based income and interest.
One common method of SCF is reverse factoring, whereby a supplier lowers the cost of financing by leveraging the buyer’s lower cost of borrowing. There are other methods, complexities, benefits, and risks behind SCF, but small and large businesses should consider this emerging form of financing to improve its supply chains.
References
International Finance Corporation, World Bank. “Supply Chain Finance Knowledge Guide”. 2014.
