Forfaiting is a financing method whereby the forfaiting company purchases a payment receivable at its face value (invoice value) minus costs which are composed of a discount and a risk premium.
The existence of payment receivables can be proved by the Exporter with a promissory note, an accepted bill of exchange or a letter of credit for instance, that will be endorsed and handed over to the forfaiter.
Based on the creditworthiness of the importer and the country where he is located , the forfaiting company usually requires guaranties from its local bank and the letter of credit to be confirmed by a bank of good standing (“aval”).
As a result, the ownership of the payment receivable which is a debt-based asset, is transferred to the Forfaiting company which becomes the new owner and the Exporter receive the full payment (minus fees, discount, etc).
Then the debtor or the Importer is usually notified by the forfaiter that the payment will have to be made directly to him at maturity.
It must be pointed out, that unlike the Factoring technique , forfaiting is a non-recourse transfer of trade receivables which is to say that in case of non-payment, the forfaiting company bears the full risk of loss.
Although, forfaiting companies can be part of major Banks, they are usually standalone entities specialised in financing and trading receivables which are coming from international trade activities of their clients.
In summary, by using the services of a Forfaiting institution, the Exporter transfers all the risks engendered by an international trade transactions such as :
Credit Risk or Non-payment risk
Foreign currency risk
Country and political risk
This financing method allows Exporters to offer extended payment terms (short to medium-term ) to their buyers more easily since the capital linked to the sales transaction is paid in full as soon as the goods are received by the importer.
Given that the cash flow situation of exporters is not impacted, credit scores and credit lines provided by banks remain unaffected since the transfer of receivables are made a non-recourse basis (risk of non-payment passed through to forfaiting company ) .
This point is extremely important since payment terms is a key component of a good offer and more often than not, this is what can make the difference between two competitive offers.
Indeed by providing good payment terms, the exporter in in a better position to close a deal and set higher prices, which in turn improve his profit margin.
In much the same way, the importer’s balance-sheet will be under less pressure, since he will neither have to provide an upfront payment nor to bear the cost of borrowing the fund needed for the trade deal.
In other words, by using forfaiting the Exporter gets the cash, gets rid of the risks of the trade deal but in the same time, provides deferred payment terms to the Importer which implicitly means that he include a financing package in the deal.
Quick and Simple
Another advantage of Forfaiting is that commitment from Forfaiting institutions can be issued in less than 48 hours since they are more specialised. Moreover the documentation needed is particularly light since negotiable tools such as promissory notes, bill of exchange and letter of credit are by definition transferable.
This financing tool is therefore a very good option for Micro, Small and Medium size Enterprises ( SME’s) as they can undertake international development by externalising the risks induced by trade transactions, to a third party which is the forfaiter in this case.
The shortcoming is that the additional cost entailed by the use of forfaiting will have either to be deducted from profit or passed on through the Importer. Having said that, forfaiting can be used at the outset of a relationship with trade partners until trust is progressively gained and a better knowledge of the risk environment is acquired.
In my opinion this solution must be used where Exporters evolve in unchartered territories which is to say, in situation characterised by high level of uncertainties regarding the Buyer, his country etc..
Another shortcoming is that since the ownership of the receivable has been transferred to the forfaiter, the Importer will have to pay the forfaiting company directly. However this can be deemed inappropriate and potentially harmful for the commercial relationship.
In this case an agreement with the forfaiting and the exporter can specify that the forfaiting contract must remain confidential in which case the exporter will collect the money and transfer it at the maturity date.
Too good to be true : What’s the catch ?
Given that forfaiters do not lend money but rather purchase debt assets, their processes are more straightforward than Banks which are more regulated.
Indeed, following the 2008 financial crisis, banks have to abide with an increasing set of regulatory rules in terms of solvency ratio and capital requirement, to name but a few. As a result, they will tend to assess the risks and grant financing by making sure that their lending limit are preserved and that their balance sheet is not too much affected by the presence of risky assets. This explains to a certain extent, why credit requests require more time to be assed.
On the hand , while some forfaiters will keep the debt-assets in their balance sheet until maturity, others will decide to sell them in the secondary market to investors.
The truth is that forfaiters do not take as much risk as it appears to be, since they will only purchase debt-instruments which have been avalized by banks such as:
Promissory notes with the mention “aval”
Bill of exchange with the mention “aval”
Letter of credit confirmed either by the local bank of the Importer (if reliable enough) or by a confirming bank of good standing in the Exporter’s country.
Put differently forfaiters will only purchase debt-asset instruments that have been avalized which is a precondition for being able to sell them on the secondary market.
If for some reasons forfaiters don’t find a bank willing to avalize the debt instrument they will refuse to finance and this means that you should not make a deal with the exporter
As we can see, the discount and fees asked for by the Forfaiting institution, gives you an indication of the real risk that the importer represents and the refusal to finance your trade transaction means that you should not trade with him at all.
The advantage is that this assessment is made by people that are in the best position to determine the risks and the opportunity regarding a trade transaction since they rely on a worldwide network of banks and information providers, than can hardly be acquired by an exporter on his own.
Negotiation stage and Pricing strategy
It is worthwhile seeking advice and getting quotations at the earliest stage of a potential deal in order to determine forfaiting cost .
By doing so, the exporter can pass-through the financing cost and thus adopt the best pricing strategy with the importer.
In the case of a preliminary negotiation with a prospective importer , it is possible to obtain the commitment of a forfaiter in advance against a non-refundable fee in order to get an option for financing the future deal.
Unlike the one-shot deal forfaiting developed so far, revolving forfaiting can be activated and agreed in advance providing that they are used for receivable which are eligible.
(same customer, invoices within the limit the credit limit et..)