Forfaiting or factoring, which is the best solution for your business?

One of the main concerns for entrepreneurs is how they can collect payment for the invoices they issue for the products and services they provide to customers. Companies often find themselves in a situation where, for certain customers, they offer invoice payment terms longer than 30 days.

The main problem is that, at the same time, they still need to buy supplies, pay salaries, and cover other operating expenses. When they don't have enough liquidity to make these payments, the smooth running of the company suffers, whether we're talking about domestic or international trade.

So what can you do in this situation? How can an entrepreneur avoid waiting that long to collect invoices and keep the business running in a healthy way? The answer is financing through factoring or forfaiting.

Recently, factoring and forfaiting have become major sources of financing. Although they may seem similar to some, they differ in nature, concept, and scope.

What is factoring?

Factoring is a financial method commonly used for business financing, and it can be applied in both domestic and international trade. It involves selling receivables to a factor (an NBFI or a bank), which offers immediate payment of invoices in exchange for a fee. In practice, instead of waiting 30, 60, or 90 days until customers pay their invoices, the company gets the liquidity it needs almost instantly.

There are 3 parties involved in a factoring transaction:

1. the debtor (the buyer of goods and services),
2. the client (the seller of goods or provider of services)
3. the factor (the financier).

Selling invoices to the factoring company can be done on a recurring basis, building a long-term business relationship based on trust.

As for the contract, the factor and the client can negotiate whether the factoring transaction will take place:

• with recourse or without recourse (that is, whether the debtor's non-payment risk is assumed by the factor or by the client).
• open or closed (whether the debtor will be notified or not)

What is forfaiting?

Although it is similar to factoring, forfaiting is used only in international trade. In this scenario, the exporting company assigns the right to collect payment for the goods delivered or services provided, in exchange for immediate cash payment from a forfaiter. This gives the exporter the opportunity to turn a credit sale into a cash sale, reducing the risk of receivables not being paid by the importer.

Once the receivables have been assigned, the exporter also transfers the risks and obligations related to payment of those receivables to the forfaiter, who is responsible for collecting them by the due date. However, the exporting company still has the duty to comply with the other contractual conditions regarding the goods supplied (quality, warranty, delivery terms, etc.). The terms of the international commercial contract are independent of the forfaiting contract.

The forfaiter is a financial intermediary that provides support in international trade. The international trade transactions relevant to forfaiting are those that can be evidenced by negotiable instruments, namely promissory notes and bills of exchange.

Forfaiting is a transaction applied to receivables with payment terms of up to 1 year, as well as to those with terms of 1 to 7 years or 10 years. Even so, today forfaiting usually involves receivables with short due dates and large amounts, and it is a technique used for exporting plants, machinery, and other high-value goods.

The criteria exporters need to consider when using forfaiting are:

• The types of debt instruments accepted as documents for forfaiting (bills of exchange, promissory notes, letters of credit, etc.);
• Guarantee instruments requested by the forfaiter (endorsement/guarantee of credit instruments, bank guarantee letters, irrevocable non-transferable letters of credit);
• Other documents (the exporter's declaration).

Forfaiting costs include:

• Forfaiting fee, paid by the exporter to the forfaiter based on the forfaiting services provided. It involves a fixed interest rate.
• Fee, between 0.5% and 1.5% per year, set based on the debtor's solvency, the level of receivables guarantee, the estimated risk, and the payment method.
• Discount fee, the discount rate based on LIBOR for the relevant period.
• Documentation fee, if legal formalities need to be prepared.
• Service fees, payable to the bank or financial institution.

The high cost of forfaiting is justified by:

1. Country risk, which involves the economic, political, and financial analysis of the country where the importer is located and the ability of the banking system to handle future payments;
2. Transfer risk, driven by the possibility of laws being introduced to regulate foreign currency transfers abroad, as well as the importer's liabilities.
3. Currency risk, determined by the time needed to settle receivables and by fluctuations in exchange rates.
4. Commercial risk determined by the possibility that the importer may fail to pay.
5. Interest rate risk generated by the difference between the forfaiting fee and the interest rate on the foreign exchange market.

What are the differences and similarities between forfaiting and factoring?

The main difference between the two is that factoring can be applied in domestic and international trade, while forfaiting applies only to financing international trade.

In terms of the process, both forms of financing involve selling receivables to a third party to get immediate cash.

From the perspective of the due date, factoring involves selling receivables with terms of up to 90 days. Still, there are factoring companies, such as Instant Factoring, that let you sell invoices with a due date longer than 90 days. On the other hand, forfaiting mainly targets medium- and long-term receivables or those with a fairly high value.

In the case of factoring, the sale only applies to receivables that include ordinary products or services, while forfaiting focuses on selling receivables related to capital goods.

Another difference between the two forms of international trade financing is the financing percentage. In factoring, entrepreneurs receive up to 90% of the invoice value. In forfaiting, exporting companies get 100% of the value of the exported goods, avoiding different types of risk (interest rate risk, currency risk, credit risk, political risk, etc.).

In the case of factoring, the transaction can take place either with recourse or without recourse. Forfaiting is carried out only without recourse.

The cost of the factoring transaction is paid by the seller or the client, while in forfaiting, the foreign buyer is responsible for paying the forfaiting costs.

When it comes to instruments, factoring transactions are not carried out using negotiable instruments, while forfaiting is based on negotiable payment instruments.

Conclusions

Factoring and forfaiting can seem complex and hard to understand, but the best solution for your business depends on the level at which your commercial activity takes place, as well as on your business goals. If you want to learn more, contact Instant Factoring, and our specialists will tell you which of these methods best fits your business needs.