Factoring and forfaiting. International financial settlements

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Mervyn Long
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1 Factoring and forfaiting 1

2 Factoring Factoring is a transaction where the exporter sells its receivables to an institution The factoring institution buys the receivables without recourse Due to increased risk factors demand discount on the receivables 2

institution buys the receivables without recourse Due to

3 Types of factoring Maturity factoring- the factor pays the exporter at maturity of the accounts receivable Advance factoring- the factor pays the exporter in advance a specified share of the receivables 3

receivable Advance factoring- the factor pays the

4 The mechanism of factoring (1) The factoring transaction involves three parties: The seller-the exporter The debtor-the importer The factor 4

5 The mechanism of factoring (2) The receivables sold are usually invoices for the delivered products Factoring can take place with or without notification of the debtor In the case of notification the factor carries out the collection, in the case of lack of notification the exporter carries out the collection 5

of the debtor In the case of notification the factor carries out the

6 Advantages (1) Factoring is advantageous for exporters because this way they can obtain cash This can especially beneficial if companies struggle with liquidity problems In some industries factoring is the historic method of finance e.g. in textiles or apparel branches 6

companies struggle with liquidity problems In some industries

7 Advantages (2) Factoring reduces largely the risk of export sales The exporter can offer more attractive transaction terms Exporters are relieved from administration duties 7

8 When to use factoring? Factoring is more expensive than a bank loan It can happen that banks would refuse a loan to an exporter to provide him with cash but a factor would buy his receivables The factor checks the creditworthiness of the debtor and not of the seller Especially beneficial for small exporters 8

refuse a loan to an exporter to provide him with cash but a factor would buy

9 Would factors always buy the receivables? The credit history of the debtor is a crucial condition The current creditworthiness of the debtor Usually even average credit rating of the debtor is refused by factors 9

10 Is the debtor affected by factoring? Some types of debtors- usually large firms or governments have specified procedures when it comes to transferring the payment from the seller to debtor This matters especially due to the obligation of the factor to perform the collection The distinction between assignment of the responsibility to perform the work and the assignment of funds to the factor influences largely the debtor s processes Sometimes the debtor wants the seller to perform the collection 10

from the seller to debtor This matters especially due to the obligation of the factor to perform the collection The

11 Forfaiting (1) A transaction where a forfaiting institution buys withoutrecourse the debt resulting from a trade contract which is due in the future Forfaiting is usually aimed at medium-term capital goods financing The subject of forfaiting transactions are usually fixed assets As this type of goods are usually expensive the financing period may account for several years 11

medium-term capital goods financing The subject of forfaiting transactions are usually fixed

12 Forfaiting (2) Exporters are not willing to finance importers over such a long period This is why the debt of the importer is sold to forfaiters (usually banks) Forfaiting financing usually refers to transactions exceeding USD For larger transaction more than one forfaiting institutions can be involved 12

banks) Forfaiting financing usually refers to transactions exceeding 500000

13 Forfaiting (3) The forfaiting institution takes over the risk of the sales transaction. The exporter is liable for the quality and reliability of the project The forfaiter has an unconditional payment obligation 13

14 The forfaiting process Source: E. Bishop, op. Cit. 14

15 Does the bank always agree to forfaiting? The bank needs a guarantee that the debt will be paid off The debt should be freely transferable The forfaiting bank requires the debt purchased to be secured by a credible bank guarantee or the importer to be a prime buyer, e.g. government agency or a multinational company 15

freely transferable The forfaiting bank requires the debt purchased to be

16 Required documents The guarantee can take the form of: promissory notes bills of exchange, book receivables deferred payments under a letter of credit 16

17 Forfaiting paper All documents guarantying the transaction e.g. bills of exchange and promissory notes become the property of the forfaiter The documents are called forfaiting papers They are liquid assets with comparatively high yields 17

property of the forfaiter The documents are called

18 What are the costs of forfaiting?(1) The forfaiting institution demands cash for buying the debt The value of the debt is discounted at a specified rate, The forfaiting institution demands also a risk premium on the transaction 18

19 What are the costs of forfaiting? (2) The discount margin is the one of the principal costs of forfaiting Besides the discount margin the bank charges a commitment fee The discount can be computed as straight discount or discount to yield basis 19

forfaiting Besides the discount margin the bank charges a

20 Advantages of forfaiting for the exporter Conversion of a credit transaction into a cash transaction Increase of liquidity Risk elimination (market, transaction and political risks) Relieve of administration duties 20

Increase of liquidity Risk elimination (market,

21 Advantages of forfaiting for the importer The flexibility to pay for his goods Deferred payment Fixed interest cost 21

22 Discussion Factoring and forfaiting are withoutrecourse methods of trade finance. Is this always beneficial for the exporter/importer? Name examples when recourse financing would be more beneficial. 22

23 Literature E. Bishop, Finance of international trade, Chapter 10. Publication available via Science Direct Database 23

Financing international transactions. International financial settlements 120881-1165

Financing international transactions 1 Lecture outline Overview of the financing methods Exercises 2 Mode of payment vs. financing trade The mode of payment refers to terms of technical transferring the