What is Forfaiting?
Forfaiting is financing in which an exporter sells its medium or long-term accounts receivables to a third party, i.e., a forfaiter, at a discount to receive an immediate cash payment.
A forfaiter could be a financial institution, bank, insurance underwriter, trading firm, or any specialized individual/entity involved in purchasing foreign receivables from exporters.
The forfaiter pays the entire invoice amount upfront after deducting its margin. Then, it’s the forfaiter’s responsibility to collect dues from the importer upon the maturity of the credit period.
With this, the risk of default or non-payment gets transferred to the forfaiter. Since this arrangement works purely on a non-recourse basis, the exporter can no longer be liable if the importer fails to pay by the due date.
The forfaiter earns its margin through the discount rate, the amount of which is incorporated in the deal price. For instance, if an invoice (bill receivable) amounts to Rs. 1000 and the forfaiter's discount rate is 7%, the bills receivable would be purchased at Rs. 930, where Rs.70 would be the forfaiter's margin or service fee.
The discount rate could vary in different transactions, as the degree of risk involved changes in each case. The risk magnitude is assessed by considering factors such as tenure of credit, importing country, currency, repayment structure, etc.
This article covers the basics of forfaiting in great detail.
What is Factoring?
Factoring is a type of financing in which a business sells its accounts receivable/invoice to a third party, known as a factor, in exchange for an immediate advance on the invoice amount. The factor who purchases the invoice then immediately advances up to 80% of the total invoice amount. The 20% balance amount, minus the factoring fee, is paid only at the end of the maturity period once the customer pays the factor.
Under this arrangement, it’s the factors’ responsibility to collect payments from the buyer (customer), while the seller has no role to play in collecting dues. Hence, businesses can fulfill their urgent cash flow requirements, as factoring ensures the immediate availability of funds.
The factor charges a nominal service fee, typically in the 2% to 6% range. This fee depends upon various factors like market condition, size of the deal, type of factoring, quality of the portfolio, seller’s creditworthiness, etc.
The factoring service can be used in the case of international and domestic trade, wherein companies can benefit from a steady cash flow.
Simply based on their definitions, the two financing arrangements may sound near-identical. However, there are critical differences in accounting treatment and practical applications.
We've compiled this detailed guide on financial factoring to help explain the concept in greater detail
Difference between Forfaiting and Factoring
Features of Forfaiting
Some salient features of forfaiting are given below:-
- Forfaiting is an international trade finance mechanism.
- It is usually extended to export capital goods or commodities.
- Only medium and long-term bills receivables are financed, where the credit period can ranges from three months to seven years.
- It involves 100% financing without any recourse to the exporter who sells the debt.
- The minimum size/ value of the transaction tends to be more than $100,000
- It protects the exporters from multiple risks such as credit risk, money transfer risk, and other risks associated with foreign exchange rate fluctuation and interest rate changes.
- The receivables can be converted into a debt instrument, such as an unconditional bill of exchange or a promissory note. These are legally enforceable and can be easily traded in the secondary market. The timespan of these instruments could vary from one month to 10 years, with most falling in the range of one-three years.
- The forfaiter may also choose to hold the promissory notes and treasury bills until the end of the maturity period.
- In most cases, the forfaiters seek a guarantee from the importer's bank, which is provided in the form of a letter of credit (LC).
- The amount of payment is receivable in any convertible currency.
Features of Factoring
Some salient features of factoring are as listed below:
- Factoring is a form of financing that can be used for international and domestic trade.
- Factoring deals with short-term accounts receivables, i.e., those with a credit period of 90 - 150 days.
- The factor is responsible for collecting payments from the buyer.
- The factor assumes the risk of bad debts.
- Factoring can be with or without recourse. In recourse factoring, the risk of payment default isn’t transferred to the factor. In other words, the seller would have to bear the loss in case the customer/buyer defaults on payment.
- The factoring company conducts an in-depth assessment of the customer's creditworthiness and may provide valuable trade-related advice to the business.
- The factor has the right to resort to legal action, if required, to recover the due payment.
Types of Forfaiting Transactions
There are different types of financial arrangements that a forfaiter can choose:-
Forfaiting backed by promissory notes:- These are the letters of promise issued by the importer and backed by a bank, stating that the payment would be made to the exporter on a specific date. The use of promissory notes completely secures the receivables under a forfaiting transaction in favor of the forfaiter.
Forfaiting backed by bills of exchange:- Bills of exchange are similar to promissory notes. However, these are written orders that make the importer liable for payments. Bills of exchange are generally used more often in international trade, and promissory notes are used in domestic transactions.
Forfaiting backed By LCs:– This is a guarantee issued by the bank, assuring that debts will be paid, even in case of payment defaults by the importer.
Types of Factoring Transactions
Recourse Factoring:– Under this type of factoring, the credit risk remains with the seller, although the debt is transferred to the factor. This means that in case of payment default, the factor can have recourse to the seller.
Non-recourse Factoring:– Under this arrangement, the absolute risk of non-payment gets transferred to the factor, and the seller cannot be held liable for payment default. In other words, the factor has no recourse to the client.
Domestic Factoring:– This factoring arrangement works when all parties involved, i.e., the buyer, seller, and the factor, are located in the same country.
International Factoring:– This factoring arrangement is for cross-border trade, where the buyer and seller are located in different countries.
Advance Factoring:– Under this arrangement, the factor extends an advance amount (usually 75-90%) to the client at an agreed interest rate against the uncollected and non-due receivables. This type of factoring could be with or without recourse.
Maturity Factoring:– Also known as collection factoring, maturity factoring doesn’t involve any advance payment to the client/seller. Instead, the factor pays the seller on an agreed-upon due date, which is generally the average number of days the debtor takes to make the payment.
Reverse Factoring:– This type of factoring provides both the buyer and seller with a short-term credit against the invoice. The seller receives an upfront cash payment, whereas the buyer gets more time to make the payment.
Disclosed Factoring:– Under this arrangement, the buyer/debtor is notified that they have to make payments to the factor. The seller also mentions the factor's name in the invoice, asking the buyer to pay the factor directly.
Undisclosed Factoring:- Here, the buyer isn’t informed about the factoring arrangement. The factor's name is also not included in the invoice raised by the seller. The debt is realized in the name of the seller itself, although complete control of the bank account remains in the hands of the factor.
This article on the different types of Factoring will cover the concept in more detail.
Steps in a Forfaiting Transaction
- Due to the unusually long credit period, the exporter generally insists on a forfaiting arrangement to be initiated by the importer.
- The forfaiter requests documentation from all the parties. This includes information on the importer, type of goods sold, credit period, contract, currency, payment schedule, etc.
- Forfaiter assesses the risk involved in the transaction and then decides the discount rate/fee. A forfaiting transaction is also generally backed by other instruments like an LC; in cases like these, the forfaiter will also evaluate the creditworthiness of the importer’s bank.
- The importer and the exporter agree to the terms and conditions of the deal.
- The exporter seeks a guarantee from the importer's bank. The importer ensures the same to facilitate the trade.
- The exporter delivers goods to the importer and submits the documents to the forfaiter.
- As per the agreement, the forfaiter pays the exporter 100% of the invoice amount - the margin/fee (based on the discount rate).
- Forfaiter presents documents to the importer's bank upon credit maturity.
- Importer pays the bank upon credit maturity.
- Bank pays the forfaiter at the agreed date.
Company ‘A’, situated in Italy, wants to buy garments from Company ‘B,’ located in India. Company ‘B’ signs the deal but finds the payment period of 90 days quite long. It, therefore, approaches forfaiter ‘C’ to fulfill its immediate funding requirements. Company ‘B’ submits all the deal documents to forfaiter ‘C’, who analyses the risk involved in the trade and agrees to fund. The invoice amount is Rs. 1,00,000, and forfaiter ‘C’ charges a fee of 3% of the deal amount.
Company ‘B’ then notifies Company ‘A’ about the forfaiting arrangement and asks for a guarantee from its bank. Once the guarantee is provided, Company ‘B’ ships garments to Company ‘A’ and receives the complete payment after fee deduction, i.e., Rs. 97,000 (Rs. 1,00,000 minus Rs 3,000) from the forfaiter ‘C’.
After 90 days, forfaiter ‘C’ approaches Company ‘A's bank with the necessary documentation. Company ‘A’ pays its bank an amount of Rs 1,00,000. Then, the bank pays the same amount, i.e., Rs. 1,00,000, to the forfaiter.
Steps in a Factoring Transaction
- The seller conducts a credit sale with the customer and raises the invoice.
- Buyer agrees to make payment upon maturity of the credit period.
- Seller sends a copy of the invoice to the factor.
- Factor verifies the invoice with the seller and conducts its credit checks.
- Factor advances up to 80% of invoice amount upfront. This depends from factor to factor.
- Upon completion of the credit period, the factor requests payment from the buyer towards the factored invoice.
- Buyer sends complete payment directly to the factor.
- Factor deducts factoring fee from the payment amount.
- Factor returns the remaining amount to the seller.
Company ‘A’ ships toys to Company ‘B’ and raises an invoice of Rs 1,00,000, which would be due for payment after three months. Company ‘A’ requires immediate funds to run the business and therefore approaches the factoring company ‘X’ to sell the invoice. Company ‘A’ sends a copy of the invoice to ‘X’, who then asks for the necessary documentation to analyze the trade deal and assess the risk involved. If all conditions meet, ‘X’ might agree to factor the invoice and pay Rs 80,000 to company ‘A’. Once the three-month credit period is over, ‘X’ approaches Company B to clear the invoice. Company ‘B’ then pays the entire invoice amount, i.e., Rs. 1,00,000 to ‘X’. The balance amount that needs to be paid to Company ‘A’ is Rs. 20,000. ‘X’ deducts its factoring fee of 4% from this amount and extends the remaining amount, i.e., Rs. 16,000, to Company ‘A’.