A Primer on Forfaiting
Forfaiting is an important means of raising short-term finance for companies that indulge in foreign trade. With the increasingly easy availability of information regarding the creditworthiness of counterparties, the importance of contracts such as factoring is dwindling. However, it is still a pivotal financial service as far as foreign trade is concerned.
Definition of Forfaiting
The term forfaiting arises from the French word forfait which means to relinquish a right. It is essentially a form of bank financing in order to fund working capital requirements for international trade.
Forfaiting can be compared to bills discounting in many ways. This is because in case of forfaiting arrangement also, the exporter simply discounts a promissory note. In this case, the promissory note is endorsed by the importer and also has the implicit backing of the importers bank which has opened a letter of credit on behalf of the importer.
However, most forfaiting agencies do not intend to hold on to the agreement till maturity. Instead, these discounted agreements become freely tradable securities. There is an active market for forfaiting contracts in most countries of the world and banks with excess capital looking to make quick loans find forfaiting to be a worthwhile alternative.
The secondary market does not buy the contract considering it to be the liability of a foreign bank. Instead, they take the word of the forefaiting agency that the dues will be paid on a certain date at face value.
Hence, the time remaining till due date as well as the reputation of the forfaiting agency re of prime importance in the secondary market. An agency with a bad reputation will have a hard time reselling its debt.
How it Works ?
- The importer and exporter have to first work out an international trade transaction. This means that an invoice must be drawn and that the goods must be shipped to the importer and must be receivable within a period of 1 to 180 days.
- The exporter must have access to documents and promissory notes from the importer which entitles him/her to receive the payment of goods. Most forfaiting agencies would prefer an irrevocable letter of credit that is fully payable at sight guaranteed by a solvent bank. The exporter must then be willing to sign over and endorse these documents in the favour of forfaiting agencies.
- Forfaiting happens for transactions where large dollar amounts are involved. In case the amount is too large for a single agency to finance, these agencies might form a syndicate amongst themselves and provide the required amount to the exporter.
- The forfaiting agency discounts this promissory note at a certain rate of interest which reflects the risk that they are undertaking by accepting this promissory note from an overseas buyer and deliver the rest of the money to the exporter.
- Since forfaiting is always without recourse, the exporter is simply cut out of the transaction. The agency stands to receive payment from the importer's bank failing which it will simply have to write off the dues as bad debts and bear the loss.
- Forfaiting involves selling off accounts receivables without recourse. Hence, it simply removes the credit risk and country risk from the books of the exporter.
- Forfaiting provides easy and convenient access to finance. Hence, it allows the exporter to be flexible while structuring the transactions. The value added as a result of the deal becomes more important and minor issues like working capital issues are easily taken care of.
- Forfaiting does not take into account the other business assets of the exporter. None of the cash flows or the assets of the current.
- Forfaiting also shifts the risk of foreign exchange price movements from the exporters to the forfaiting agency.
Forfaiting vs. Factoring
The financial service of factoring may seem to be pretty similar as compared to forfaiting. Many people tend to get confused between the two. It is therefore important to differentiate between them. The differences between factoring and forfaiting are as follows:
- Factoring may or may not be for foreign trade. However, forfaiting contracts are exclusively drawn up when foreign trade is involved.
- Factoring without recourse works out to an arrangement wherein a company is just outsourcing their accounts receivables processing to another company. There may be no financing involved in a factoring arrangement. However, forefaiting is a 100% pure play financing agreement.
- A factoring contract may allow the factor to offload some of the credit and country risks to the seller. However, a forfaiting contract does not permit any such concessions. The agency offering forfaiting services has no option but to bear the risks themselves.
- Factoring is an arrangement for receivables which are due in a short period, lets say a month. However, forfaiting is an agreement for receivables which are due over a longer term. Forfaiting is generally done for receivables which may be due to be collected six months from now, thereby making it equivalent to a short term loan.
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