All practicing factoring brokers and commercial finance consultants, who have been in the industry even a short time, will have developed a significant expertise in factoring as a method of dealing with problems of cash flow caused by the slow paying customers of a business. And though many new to the industry may have not been familiar with the factoring product prior to their industry entry, factoring transactions are relatively straight forward and the overall concept so easy to grasp, that almost anyone can develop an in-depth knowledge of factoring in a relatively short time.
Typically, factoring provides a method of finance for traditional trade invoices with such invoices being paid in 90 days or less. Because of logistics delays, invoices for international transactions might extend as long as 150-180 days. But as far as factoring is concerned, that’s about it.
So what if an international customer placing an order for several million dollars in merchandise or equipment wanted longer terms? What if a valued customer wanted 36 months to pay? How would you finance such a transaction? Well…welcome to the world of export trade finance and forfaiting!
Forfaiting vs. International Factoring
Forfaiting is a method of trade finance that is usually international by it’s nature. In most instances, forfaited transactions are much larger than the typical factoring transaction so in concept, forfaiting is a bit similar to international factoring on steroids. Like international factoring, forfaiting is a method of trade finance that…
- utilizes a purchase / sale styled transaction rather a more traditional borrower / lender style
- provides immediate payment to the client (typically an exporter) for a sale of goods or services (most often capital goods or commodities)
- completely eliminates the risk of non-payment by the customer (importer)
- eliminates payment risks associated with currency fluctuations and political upheavals
- eliminates the need for credit insurance
- is based upon paper. The debt instruments involved in factoring are commercial invoices. The debt instruments involved in forfaiting are usually bills of exchange, promissory notes, or extended-term letters of credit.
Unlike international factoring, forfaiting addresses the financing of trade debt other than what is considered short-term (180 days or less). Whereas a normal international factoring transaction may finance an invoice due in 150 days, forfait transactions usually involve medium term obligations of 180 days to as long as 10 years. The obligations usually represent a large transaction involving capital goods or commodities with a value of $1,000,000 to as much as $50,000,000.
Another way to distinguish a factoring transaction from a forfaiting transaction is to compare terms of payment. The payment terms on a factored invoice are typically “pay the invoice in full within 90 days or less”. The payment terms for a sale in a forfait transaction are quite different and the balance due is broken down and divided into a series of usually equal payments, collectible over time, and represented by sequential promissory notes or bills of exchange.
Example: Forfaiting vs Factoring
Let’s say the buyer (importer) of a $5,000,000 piece of equipment wants to seller (exporter) to grant 5 year payment terms. The payments are negotiated to be made in 10 equal and sequential installments, and each being six (6) months apart. The installments are represented by promissory notes with one note maturing every six (6) months in a series. Each installment represents $500,000 principal plus interest for the period.
In an international factoring transaction, a factor would simply buy the entire, single $5,000,000 invoice at a discount and the transaction would typically settle in 150 days or less.
In a forfaiting transaction, the forfaiter buys all of the 10 promissory notes or bills of exchange at the conclusion of the sale and at a formulated discount to each note’s face value. The forfaiter immediately remits the proceeds to the exporter on a non-recourse basis. The first note, due in six months would have a small discount. The 10th and final note due in the 5th year would reflect a larger, more sizable discount since the forfaiter must wait 5 years to collect.
In either transaction (factoring or forfaiting), the exporter (seller of goods) is paid immediately and is then out of the transaction altogether. All forfaiting transactions are non-recourse, so should the importer default on one of the promissory notes, there is no recourse back to the exporter and it is up to the forfaiter to collect.
One unique characteristic of forfaiting is that all promissory notes or bills of exchange purchased must be “avalized”, or carry a payment guarantee from a bank that is acceptable to the forfaiter. In most cases, the importer will arrange for the aval attachment through it’s own business bank.
Basic Workflow of Typical Forfait Paper Transaction
As mentioned, factors simply purchase trade invoices. Forfaiters are different. They buy promissory notes or bills of exchange that each represent a “portion” of an invoiced transaction. In a forfait financing arrangement…
- An importer contacts an exporter and requests a sale of goods with intermediate terms. The exporter typically does not grant intermediate terms but will quote the price of the sale based upon possible financing and loan guarantees (the “aval”).
- The exporter, contacts a forfaiter and lays out the transaction with details including the name of the buyer, country of buyer, and name of the bank issuing the aval. etc.
- The forfaiter provides a “provisional” quotation to the exporter who forwards the details to the importer.
- If acceptable, a commitment fee will now be paid to the forfaiter.
- The importer now prepares the promissory notes or bills of exchange in favor of the exporter and arranges for it’s bank to attach the aval. These documents are prepared without firm dates pending shipment or receipt of the goods. When the goods are shipped or received, the exporter will endorse the notes or bills and make them payable to the forfaiter “without recourse”.
- Everything is now in place for the goods to be manufactured or shipped. Once received by the importer and inspected, the final dating and preparation of the bills or notes is completed and they are purchased by the forfaiter.
It’s important to note that when approached by a buyer / importer to provide intermediate payment terms for a sale, the exporter should contact the forfaiter PRIOR to quoting a firm sale price. Though the discount earned by the forfaiter on the notes with the shortest maturities can be easily absorbed in most transactions, the discounts on the notes with the longest maturities may be so substantial as to make the sale unprofitable to the exporter if based upon standard pricing. The exporter needs to determine the total discount required by the forfaiter on all notes or bills and add that amount to the sales price of the goods before providing a firm quote to the importer.
Forfaiting and U.S. Based Factoring Brokers
On a comparative basis, estimated annual forfaiting volume worldwide of approximately $50 billion is minascule when compared to the trillions of dollars of volume in factoring. Because of this relatively small size, only the most professional commercial finance consultants will be familiar with forfaiting and it’s occasional need or use. It is estimated that only 2% of world trade is financed through forfaiting and much of that in what can be considered “developing economies”, where banking systems are not fully developed and where there is no formal export-import bank in place. In the U.S., the many exceptional financing programs offered by EXIM (the Export-Import Bank of the United States) eliminate the need for forfaiting in most cases, however forfaiting is occasionally used to supplement EXIM financing programs and to insure payment on that portion of a transaction not covered or insured by EXIM guarantees.
For U.S. based factoring brokers and commercial finance consultants, it is only necessary that you know that forfaiting exists and how it can be used as a supplement to EXIM programs. For most international transactions requiring payment terms other than normal 120-150 days, your first stop for financing will most always be EXIM.
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