What is Forfaiting – Benefits and Process with Steps
Forfaiting is a financial process involving the management of finance exports. It aids businesses by helping them manage their foreign exchange risk. It involves a business selling its accounts receivable to a financial entity at a discounted rate in exchange for immediate payment. Forfaiting usually involves medium and long-term receivables and is usually carried about by financial firms that specialise in the area of export financing.
Before we dig deeper, let’s know how forfaiting works.
How does Forfaiting Work
Forfaiting empowers businesses by allowing them to receive payment for their goods and services upfront rather than waiting for the importer to pay the invoice. This can be especially useful for businesses that may not have the financial resources to wait for payment or to absorb the risk of non-payment.
In this process, the forfaiter will immediately pay the exporter a percentage of the invoice amount. In return, the exporter transfers the rights to the invoice to the forfaiter. Then the forfaiter will collect the full invoice amount from the importer.
In the event that the importer does not pay the invoice amount, the exporter is in no way held accountable. Instead, the forfaiter who has bought the invoices will be responsible for covering the loss. This practice of assuming the risk by the forfaiter is known as a “non-recourse” transaction model.
In most cases, the importer’s bank will guarantee the amount to be paid towards the invoice. The receivables are generally converted to debt instruments. This allows it to be freely traded on a secondary market and is legally enforceable, thus lending some level of security from risk to the forfaiting entity.
As a result, a forfaiting transaction acts as a security blanket for businesses by offering them monetary stability. This, in turn, allows them to focus their energies on critical operational issues and core business tasks instead of worrying about collecting payments and invoices.
When Can Forfaiting Occur
Forfaiting is usually seen in the area of international trade. It is popular in scenarios where there is a sale of goods amounting to $100,000 and above between two or more countries. As mentioned above, it is most commonly used by companies that do not have adequate working capital to fund their operational cycle in the absence of a continuous cash supply.
It is also used in cases when the exporter wants to move to a risk-free position in case of payment default by the importer.
Characteristics of Forfaiting
1. High-Cost Orders
Forfaiting as a tool is usually associated with orders and transactions of larger values. While it is not unusual for forfaiting to be used for a transaction above $100,000, in most cases, a typical transaction involves a minimum amount payable that falls between$ 250,000 and $ 500,000, if not more.
2. Credit Term
It is usually medium or long-term projects that use forfaiting. As a result, the credit terms also fall in the medium and long credit horizon, ranging from 6 months to several years, based on the project.
3. Contractual Nature
Forfaiting acts as a contract for goods and services drawn among the exporter, importer, and forfaiting entity. It involves a letter of guarantee or credit extended on the importer’s behalf by a financial firm.
4. Complex
Due to the nature of foreign trade and the intricacies of currency exchange, the forfaiting process generally comprises complex transactions. Forfaiting firms typically also extend more nuanced and complex services, such as providing competitive pricing and handling all the collection and documentation processes.
5. Risk
One of the distinguishing features of forfaiting is the benefit of complete risk absorption that it extends to exporters. Assuming the credit risk of the exporter’s buyers allows the business to focus its energies on doing business instead of payment collection and invoice formalities.
Steps Involved in Forfaiting
While forfaiting involves large orders and complex transactions, the basic steps involved in the process are straightforward. Here is the basic steps in a forfaiting transaction:
- The exporter and importer decide on a potential sale and agree on factors such as order value and prices.
- Simultaneously, the exporter must choose a forfaiter that can cater to their financial requirements, risk tolerance, and nature of business.
- The exporter and the forfaiter decide upon a price. This is done early so the exporter can incorporate the forfaiting cost into the final transaction.
- After receiving the final costs from the exporter, the importer secures a financial guarantee from a local financial firm to facilitate the transaction in the form of documents such as a bill of exchange or promissory note.
- The exporter ships the goods/ commodities and receives bank guarantee documents.
- The bill of exchange or promissory note is provided to the exporter.
- The exporter endorses these negotiable instruments without recourse in favor of the forfaiter.
- After due diligence, the forfaiter pays the exporter a sum as decided in the agreement. This is generally the face value of the bill minus the discounted amount.
- Thus, the forfaiter gains complete control over the negotiable instruments.
- On maturity, the forfaiter submits the relevant documents to the importer or the importer’s bank, which makes the required payments.
Documents Required for Forfaiting
Given the nature of the forfaiting process, several documents are required to set the transaction in motion. They are:
- Supply contract between importer and exporter with relevant payment details.
- Shipping documents with air/ railway bill, certificates of export and receipt and any other equivalent or relevant transport documents.
- An attested commercial invoice.
- Letter of assignment and notification to the guarantor.
- Letter of guarantee on behalf of the importer.
Other information that is required for the process of forfaiting includes the identity of the buyer, including their nationality, the nature of the goods, the value of the transaction, currency of contract and credit terms, payment schedule and associated interest rates, identity of the guarantor of payment and duration of the contract.
Advantages of Forfaiting
1. Immediate Settlement
Forfaiting’s most significant benefit is that it provides businesses upfront payment for their goods or services upfront, instead of them having to wait for a stipulated period for the customer to pay the invoice.
2. Risk Absorption
Forfaiting process involves transferring the risk of non-payment from the export to the forfaiter. This benefits the exports as they can focus on their primary business activities and not waste their resources on activities such as payment collection.
3. Generates Cash Flow
For businesses that do not have the financial resources to wait for extended periods to receive payment or absorb the risk of non-payment, this is a valuable financial tool as it generates cash flow and empowers the business with access to capital.
4. Improving Creditworthiness
Forfaiting is also an important tool that helps to enhance a company’s creditworthiness. This critical parameter improves the company’s financial standing for future economic requirements.
5. Reduces Company Costs
Forfaiting can go a long way in reducing the costs of businesses as it can eliminate the workload and resources employed towards maintaining a large accounts receivable staff. It also eliminates the need for a company to purchase expensive credit insurance.
6. Flexible
Forfaiting is flexible as it can be tailored to meet the unique demands of each business. It also does not involve stringent eligibility criteria, as seen in banks.
7. Reduced Currency Risk
Most forfaiting firms enable exporters to accept payment in their currency. This reduces the scope of any risk associated with currency fluctuations.
8. Access to New Markets
Forfaiting eases the process of international trade and facilitates new market opportunities for businesses. It encourages businesses to explore multinational trade without worrying about factors like credit risk.
Disadvantages of Forfaiting
1. Expensive
The costs associated with forfaiting are generally higher than financing provided by financial institutions such as banks. This is because the scope of risk being absorbed by forfaiting is higher than traditional financial firms, leading to higher export costs.
2. Limited Scope
Forfaiting is usually applied to large-scale orders or transactions, generally on a higher value. Therefore, small businesses and specific industries may not be able to enjoy the full benefits of forfaiting.
3. Increases Dependency
Given the benefits extended by forfaiting, some companies are at the risk of becoming too dependent on forfaiting. This can lead to a financial plan that depends on only one kind of lender or monetary source, which is not always a good idea.
4. Regulatory Differences
In several countries, forfaiting does not come under the preview of regulatory authorities. As a result, in such countries, these businesses may not be protected by the regulatory bodies leading to potential issues.
Final Word
Forfaiting is a financial instrument that enables exporters to collect payment for their goods or services upfront without having to depend on the payment schedule of the importer. It allows exporters to be risk-free and manage their cash flow efficiently.
On the other hand, forfaiting can be an expensive financial tool. Therefore, it is crucial for businesses to weigh the pros and cons of forfaiting before choosing a plan. It is also advisable to speak to a financial advisor to understand how it can be included in your business ecosystem.
FAQs
Ans; The cost of forfaiting is paid for by the exports. After deducting their costs, the forfaiter will pay the final amount to the export.
Ans; In forfaiting, the risk is always absorbed by the forfaiter. Therefore it is done without recourse, unlike factoring, which can be done with or without recourse.
Ans; The exporter, the importer, and the forfaiter are the three main parties involved in forfaiting.
Ans; Forfaiting is an expensive proposition due to the high level of risk involved. Additionally, it has a limited scope as it usually handles large orders of significant monetary value, thereby eliminating small businesses from using it.
Ans; A promissory note refers to a legal document that explains the terms of financial transactions such as loans. It contains data such as the loan amount, interest rate, repayment schedule, and other specifics.
