Forfaiting is a method of obtaining medium-term funds for a business involved in international trade. The process consists of a company engaged in exporting the capital goods, selling foreign accounts receivables like promissory notes or bills of exchange, and immediately receiving the financing.
The receivables owed by the importer are sold to the forfaiter at a discounted rate and without recourse in exchange for cash. These are eligible for trading in the secondary markets. The forfaiter usually is a third-party or intermediary, such as a financial institutionFinancial InstitutionFinancial institutions refer to those organizations which provide business services and products related to financial or monetary transactions to their clients. Some of these are banks, NBFCs, investment companies, brokerage firms, insurance companies and trust corporations. or bank capable of taking on the associated risks of the exchange.
- Forfaiting meaning refers to an option businesses explore to obtain funding while involved in international trade.
- The forfaiters are usually financial institutions, banks, insurance underwriters, or trading companies.
- Forfaiting and factoring are not the same, although both are methods of obtaining funds while involved in a trade. Forfaiting, on average, has more benefits, but it may be more costly to receive funds.
- A few of the advantages include mitigating the risk involved with trading and covering 100% of the necessary funding for completing the transaction.
How Does Forfaiting Work?
Many times, businesses in international tradeInternational TradeThe trading or exchange of products and/or services across international borders is referred to as international trade. It frequently includes other risk factors such as exchange rate, government policies, economy, laws of the other nation, judicial system, and financial markets that impact trade between the two. run into the issue of delivering goods or services on time, only to be paid months later. For some companies, this way of doing business is unachievable. So, they need the funds upfront for things like:
- Paying their employees
- Purchasing necessary supplies
- Ensuring the order is complete and on time
These issues can create a dilemma for the supplier (exporter) when they need funds to continue day-to-day operations. Importers also have the desire to get the products and ensure the order’s accuracy before making payments.
Luckily, businesses have options nowadays to finance and receive the funds upfront through forfaiting instead of waiting and receiving the funds from the importer. Forfaiting was created in Switzerland in the 1950s to bridge the “payment gap” between the exporter and the importer. Now businesses can partner with a financial institution such as a bank or insurance underwriter, hiring them as a forfaiter. This process will typically involve selling foreign accounts receivables such as:
- Promissory NotesPromissory NotesA promissory note is a negotiable instrument that represents the debtor's or the writer's (the maker's) written consent to pay a promised sum to the creditor (the payee) on a specified date. – A written letter signed by a party stating the intention to pay a specified amount on a specific date.
- Accounts ReceivablesAccounts ReceivablesAccounts receivables refer to the amount due on the customers for the credit sales of the products or services made by the company to them. It appears as a current asset in the corporate balance sheet. – Claims on money due for sold products or services.
- Bills of ExchangeBills Of ExchangeBills of exchange are negotiable instruments that contain an order to pay a certain amount to a particular person within a stipulated period of time. The bill of exchange is issued by the creditor to the debtor when the debtor owes money for goods or services. – It is essentially an IOU for goods or services within an outlined amount of time.
- Letter of CreditLetter Of CreditA letter of credit is a payment mechanism in which the issuer's bank gives an economic guarantee to the exporter for the agreed payment amount if the buyer defaults. In international trade, buyers employ LC to reduce credit risk. – A guarantee from a bank ensuring the supplier will get paid.
Steps Involved In Forfaiting
After the forfaiter accepts the receivables, it will draw up a contract that both it and the supplier will sign. The agreement will usually state specifics of the transactions, such as:
- The foreign accounts receivables being purchased
- The amount it will be purchased for
- The date and any other documents
The forfaiter will typically purchase the goods at a discount rate which will be outlined in the contract. The supplier can use the funds to continue operations rather than waiting to be paid by the importer.
It will then deliver the goods or services to the buyer (importer). Since forfaiting deals are non-recourseNon-recourseA non-recourse loan is one in which the borrower must attach some form of collateral security to the loan contract, such as property, equipment, or bank fixed deposits, in order for the loan to be approved. In the event of default, the lender has the right to seize the collateral in order to clear the dues. and the responsibility is transferred to the forfaiter, it would be up to the forfaiter to collect the payments from the buyer.
Real-World Example Of Forfaiting
An example in real life can be observed with several financial institutions and other providers like banks or insurance underwriters. In this example, we will be discussing what the forfaiting process would look like with Swiss Forfait (SF), a financial institution that primarily deals with this.
When a business is looking to export goods or services but does not want to take on the risks associated with the transactionRisks Associated With The TransactionTransaction risk is the uncertainty or loss caused to the contracting party due to a change in the foreign exchange rate or currency risk on delay in settlement of a foreign transaction. or does not have the funds necessary to continue operations, they can contact Swiss Forfait (SF) to provide forfaiting services. The process would look like the following:
- The seller will contact Swiss Forfait (SF) looking for their services.
- SF will ask the seller for details about the exchange as well as request any necessary documents.
- The financial institution accepts the foreign accounts receivables from the seller.
- SF will outline the terms and conditions of the agreement, including the goods being purchased and the discount price.
- The seller and SF will enter into a contract that explicitly states the accounts receivables, purchasing price, the date, and necessary documentation.
- The seller will deliver the products or services to the buyer.
- SF will pay the seller the agreed-upon fees.
- The bank of the importer will then pay SF
- SF will collect the payments from the buyer.
Forfaiting vs Factoring
Factoring is another method that businesses can utilize to obtain funds when needed for international trading. However, these methods do have several differences.
|Forfaiting is used exclusively for international trade||Factoring can be used in international or domestic trade|
|It involves both exporter and importer||It only involves the exporter|
|Forfaiting covers the entire purchasing amount||Typically, factoring only covers around 80 to 90% of the purchasing amount|
|It pays cash for medium and long–term receivables||It pays cash for short–term contracts|
|Forfaiting involves financial instruments that can be sold in a secondary market||Factoring only consists of the money due or accounts receivables|
|It is usually used for capital goods||It is primarily used for consumer goods|
|Forfaiting is always non-recourse||Factoring can be recourse or non-recourse|
Pros & Cons
Forfaiting has some impressive benefits for all parties involved. However, it also involves a few drawbacks.
|Able to finance up to 100% of the contract value||The cost can be higher than other financing options|
|Provides immediate funds||Must meet a certain threshold amount (currently $100,000 in the US)|
|Allows businesses to expand and grow operations through exporting to other nations||Not a suitable method for short-term transactions|
|The risk is mitigated by involving multiple parties||Primarily used for capital goods|
|Flexible funding option||Currency problems make forfaiting unfavorable at times|
|Forfaiting can involve fixed interest rates||In some cases, the higher cost can be passed to the buyer|
This has been a guide to What is Forfaiting & its Definition. Here we discuss how it works along with examples and its pros and cons. You may also have a look at the following articles to learn more –