What is Factoring and Forfaiting – Key Differences – Finance is a crucial part for any business to be successful. In Exports, cost of finance is affected by many factors including domestic and international factors. Traditional methods of finance like bank loans, equity financing etc. have lot of terms and conditions attached which are difficult to meet for new or small exporters. For instance new firms may find it difficult to raise bank loans (since there is no proof that business will be viable, no balance sheets to show healthy profits). Equity participation implies a more long-term commitment and accountability towards the shareholders.
In this context the two financing methods of factoring and forfaiting could provide viable options. Both provide immediate cash to the exporter that virtually wipes out (for the exporter) the credit period extended to the importer. The exporter receives immediate reimbursement of the receivables less the discount due to the factoring or forfaiting agency. However the conditions and stipulations governing factoring and forfaiting are a little different.
What is Factoring and Forfating ?
Factoring also known as account receivables factoring or debtor financing , is a method in which a company (client) sell its account receivables (debt) to a bank or financial institution (called factor) at a certain discount.
There are three parties involved in factoring contract –
- Debtor (Buyer of Goods) – One who has purchase goods or services on credit and has to pay for same once the credit period gets over.
- Client (Seller of Goods) – who has supplied goods or services to the customer on credit terms.
- Factor (Financier) – who purchase the account receivables from client (seller of goods) and collect the money from debtor of his clients.
In other words, Factoring is a mechanism in which an exporter (seller) transfer his rights to receive payment against goods exported or services rendered to the importer, in exchange for instant cash payment from a forfaiter.
Factoring is prevalent in business in various ways. For example, Credit Card. Factoring is often more short term than forfaiting and is applicable where receivables are due within around 90 days.
1 – Client concludes a credit sale with the customer
2 – Client sells the account receivable to the factor (financier) and notify the same to customer
3 – Factor makes a part payment (advance) against the account receivable purchased after adjusting the discount or commission and interest on advance.
4 – Factor maintains the customer’s account and follows up the payment
5 – Debtor makes the payment due to the factor
6 – Factor makes the final payment to the client when the account receivable is collected or on a guaranteed payment date.
Factoring may be recourse or non recourse.
In recourse factoring, Factor buys the account receivable from client with an agreement that the client will buy them back if they remain uncollected from debtor.
Whereas in Non Recourse factoring, Client sells the account receivables to Factor without any obligation of buying them back if they remain unpaid by the debtor. As Factors have to bear any losses arising on account of irrecoverable debts, factor charges higher commission in this type of factoring.
In Forfaiting, Exporter sell their medium and long term account receivables at a discount and obtain cash from the forfaiter on non recourse basis. In Forfaiting, there is no risk for exporter of importer becoming insolvent as there is 100 percent finance of contract value. Forfaiting is generally evidenced by a legally enforceable and transferable payment obligation such as bills of exchange, promissory note, a letter of credit.
Forfaiting is a specialized form of factoring which is undertaken on export transactions on a non recourse basis.
The major parties involved in a transaction of Forfaiting are : An exporter, an importer, a domestic bank, a foreign bank and a primary forfaiter.
Exporter sells the goods to importer on deffered payment basis. Importer issues series of promissory notes undertaking to pay the exporter in installments with interest.
Importer approaches its banker (Avalling Bank) for adding the bank gurantee on the promissory note that the payment will be made on each maturity date. The promissory notes are now avallised and sent to exporter.
Avalled notes are sold to forfaiter (usually exporter’s bank) as a discount at a non recourse basis and exporter obtain finance from forfaiter.
Forfaiter hold till maturity date and obtain payment from importer’s bank / avalling bank or sell it in the secondary market or sell it to a group of investors.
Key Differences between Factoring and Forfaiting
|Basis for difference||Factoring||Forfaiting|
|Definition / Meaning||Factoring is the process in which you receive advance against account receivables / debt from the factor (bank or financial institution) without waiting for payment in future.||In Forfaiting, Exporter sell their medium and long term account receivables and obtain cash from the forfaiter.|
|Maturity of Receivables||It involves account receivables of short term maturities||It involves account receivables of medium and long term maturities.|
|Extent of Finance||Usually 80-90 percent of the value of invoice.||100 percent of value of invoice.|
|Type||Recourse Factoring and Non Recourse Factoring||Non Recourse|
|Credit Worthiness||Factor does the credit rating in case of no recourse factoring transaction.||Forfaiting Bank relies on the creditability of the Avalling Bank.|
|Cost||Factoring Cost is borne by the Client (seller).||Cost of forfaiting borne by the overseas buyer|
|Services Provided||Day to Day administration of sales and other allied services are provided||No Services are provided|
|Negoatiable Instruments||No dealing with Negotiable Instruments||Forfaiting is evidenced by bills of exchange, promissory note, a letter of credit.|