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Difference between factoring and forfaiting in export finance

Factoring and forfaiting are two distinct methods of export financing, each with its own characteristics and applications. Explore the key differences between factoring and forfaiting in this blog.

Export financing is a key step in international trade, providing businesses with necessary capital to sustain their operations and navigate payment challenges. Two prominent methods of export financing are factoring and forfaiting. While these terms are sometimes used interchangeably, their nature, concept, and scope differ. Exporters must understand the difference between factoring and forfaiting to make better trade financing decisions.

What is factoring?

Factoring is a vital financial arrangement that allows businesses to accelerate their cash flow by receiving immediate payment for their accounts receivable. Rather than waiting for customers to make the payment, businesses can sell their pending invoices to a third party, known as a factor, at a discounted rate. In return, the factor assumes or takes over the risk of non-payment and provides an upfront payment to the business, ensuring a steady cash flow.

Factoring applies to both domestic and international trade. It offers flexibility in contract negotiation, enabling parties to determine terms of the agreement, including costs, timeframes, legalities, and more¹.

What is forfaiting?

Forfaiting, on the other hand, is another form of export financing that allows exporters to convert credit sales into immediate cash. In this arrangement, exporters relinquish their rights to receive the total payment for goods or services provided to an importer in exchange for instant cash from a forfaiter, a financial intermediary specializing in international trade. Forfaiting transactions are typically supported by negotiable means like bills of exchange and promissory notes.

Forfaiting primarily focuses on financing the sale of receivables for capital goods, particularly those with short transaction periods and high values. It is often utilized in the context of medium- to long-term accounts receivables².

Difference between forfaiting and factoring

Factoring and forfaiting are two distinct methods of export financing, each with its own characteristics and applications. Below are a few points that outline the major differences between factoring vs forfaiting:

Nature of transaction:

Factoring involves the sale of trade receivables to a factor, typically a bank, in exchange for immediate cash payment. On the other hand, forfaiting is a form of export financing where the exporter sells the rights to trade receivables to a forfaiter and receives instant cash.

Maturity of receivables:

Factoring deals with short-term receivables that fall due within a period of 90 days. In contrast, forfaiting focuses on medium to long-term accounts receivables.

Goods involved:

Factoring primarily involves the sale of receivables related to ordinary goods and services. Conversely, forfaiting is specifically concerned with the sale of receivables on capital goods.

Financing percentage:

Factoring generally provides financing up to 80-90% of the value of the receivables. On the other hand, forfaiting offers full financing, covering 100% of the value of the export.

Recourse:

Depending on the agreement, factoring transactions can be recourse or non-recourse. Recourse factoring means the seller retains non-payment risk, while non-recourse factoring transfers the risk to the factor. Forfaiting, on the other hand, is always non-recourse, as the forfaiter assumes the risk.

Cost responsibility:

In factoring, the seller or client typically incurs the cost. Forfaiting, however, shifts the cost burden to the overseas buyer.

Involvement of negotiable instruments:

Forfaiting involves the using bills of exchange and promissory notes, which play a crucial role in the financing arrangement. Factoring, on the other hand, does not typically involve negotiable instruments.

Secondary market:

Factoring does not involve a secondary market for the receivables, meaning that the transaction is complete once the receivables are sold to the factor. In contrast, forfaiting has a secondary market where the receivables can be traded, enhancing liquidity and providing additional opportunities for investors. While both factoring and forfaiting aim to expedite cash flow, they diverge significantly in terms of process, timing, receivables, risk allocation, financing options, cost responsibility, and the involvement of negotiable instruments. These distinctions highlight the unique characteristics and applications of factoring and forfaiting in the realm of export finance.

Understanding these differences between forfaiting vs export factoring is crucial for businesses engaged in international trade. By evaluating this, businesses can determine which financing option aligns better with their requirements, allowing them to effectively manage their cash flow and mitigate risks associated with delayed payments.

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Frequently Asked Questions

What type of negotiable instruments are used in forfaiting?

The negotiable instruments commonly used in forfaiting include bills of exchange and promissory notes, and sometimes letters of credit. These instruments serve as legal documents that facilitate the transfer of rights to trade receivables in forfaiting transactions.

What are the limitations of factoring?

Some limitations of factoring include potential high costs, dependence on the creditworthiness of customers, limited control over customer relationships, and the inability to factor in certain types of receivables or industries.

What is an example of forfaiting?

An example of forfaiting is when an exporter sells their long-term accounts receivable for capital goods, such as machinery or equipment, to a forfaiter in exchange for immediate cash payment.

Is factoring or forfaiting right for my business?

Determining whether factoring or forfaiting is suitable for your business depends on various factors, such as the nature of your trade, types of goods involved, risk tolerance, and financing needs. Consulting with financial experts can help you make an informed decision.

What is the difference between a confirmed LC and a standby LC?

A confirmed LC is a payment guarantee that assures the exporter of payment upon meeting specified conditions. A standby LC acts as a backup to support the importer’s payment obligations in case of default.

Published on October 18, 2023.

Sources:
1. https://tradefinanceanalytics.com/what-is-factoring
2. https://www.trade.gov/forfaiting
3. https://www.investopedia.com/terms/f/forfaiting.asp
4. https://www.nibusinessinfo.co.uk/content/advantages-and-disadvantages-factoring
5. https://www.tradewindfinance.com/news-resources/international-trade-finance-companies-factoring-vs-forfaiting/
6. https://www.fundthrough.com/blog/invoice-factoring/invoice-factoring-rates-what-can-i-expect/

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