Factoring and Forfaiting

Dr K Ramesha
Professor
 Factoring Services - Concept
• Factoring services started in US in early 1920s and were
introduced to other parts in 1960s
• Factoring is a financial service covering the financing
and collection of accounts receivables in domestic as
well as in international trade
• Basically, factoring is an arrangement in which
receivables on account of sale of goods or services are
sold to the factor at a certain discount. As the factor gets
the title to the receivables on account of the factoring
contract, factor becomes responsible for all credit
control, sales ledger administration and debt collection
from the customers
 Factoring Services - Concept
• A study group appointed by International
Institute for the Unification of Private Law
(UNIDROIT), Rome 1988 defines
• “factoring means an arrangement between a
factor and his client which includes at least two
of the following services to be provided by the
factor;
– i) finance,
– (ii) maintenance of accounts,
– (iii) collection of debts and
– (iv) protection against credit risk
 Factoring Services - Concept
Deliver of goods

Client Customer
Order placed

Client submits invoice

Customer pays
Factor-Prepayment

Monthly statements

Factor
Factoring Services - Mechanism
• Buyer
– Buyer negotiates terms of purchasing the
material with the seller
– Buyer receives delivery of goods with invoice
and instructions by the seller to make
payment to factor on due date
– Buyer makes payment to factor in time or gets
extension of time or in the case of default is
subject to legal process at the hands of the
factor
Factoring Services - Mechanism
• Seller
– MoU with the buyer in the form of letter exchanged
between them or agreement
– Sells goods to the buyer as per MoU/agreement
– Delvers copies of invoice, delivery challan, MoU,
instructions to make payment to factor given to buyer
– Seller receives 80 percent or more payment in
advance from factor on selling the receivables from
buyer to factor
– Seller receives balance payment from factor after
deduction of facto’s service charges etc.
 Factoring Services - Mechanism
• Factor
– Factor enters into agreement with seller for rendering factoring services
– On receipt of copies of sale documents as referred to above makes payment
to seller of the 80 percent of the price of the debt
– Factor receives payment from the buyer on due dates and remits money to
seller after usual deductions
– Factor also ensures that the following conditions met to give full effect to
factoring arrangements
• Invoice, bills or other documents drawn by the seller should contain a clause that
these payments arising out of transaction as referred to or mentioned in might be
factored
• Seller should confirm in writing to the factor that all the payments arising out of
these bills are free from any encumbrances, charge lien, pledge, hypothecation or
mortgage or right of set-off or counter claim from another
• Seller should execute a deed of assignment in favor of the factor to enable him to
recover the payment at the time or after default
• Seller should confirm that all conditions to sell-buy contract between him and the
buyer have been complied with and the transactions complete
• Seller should procure a letter of waiver from a bank in favor of factor in case the
bank has a charge over the assets sold to buyer and the sale proceeds are to be
deposited in the account of the bank
 Factoring Services - Concept
• Parties to factoring – client, customer and
factor
• Cost of factoring
– Service fee (for administrating the sales
ledger as well as protection against bad debts
– as a percentage of invoice value or number
of invoices)
– Discount charges (advance provided by factor
and is interest which is PLR plus or minus)
 Types of Factoring Services
• Recourse and Non-recourse Factoring
– A brief discussion
• Advance and Maturity Factoring
– Advance paid against invoice where as in maturity
factoring payment is made against guarantee or
collection of receivables
• Full Factoring
• Disclosed and Undisclosed Factoring
– Name of the factor is disclosed in the invoice by the
supplier/client asking the customer to make payment
to the factor
 Factoring Vs Bills Discounting
• Similarities – many
• Differences
– Bill discounting is always with recourse, factoring can be either with
or without recourse
– In bill discounting drawer undertakes the responsibility of collecting
the bills and remitting the proceeds to financing agency, whereas a
factor usually undertakes to collect the bills of the client
– Bill discounting facility implies only provision of finance but a factor
also provides other services like sales ledger maintenance and
advisory services
– Discounted bills may be rediscounted several times before they
mature for payment. Debts purchased for factoring cannot be
rediscounted, they can be refinanced
– Factoring implies the provision of bulk finance against several unpaid
trade generated invoices in batches, bill financing is individual
transaction-oriented – each bill is separately assessed and
discounted
– Factoring is an off-balance mode of financing
– Bill discounting does not involve assignment of debts as is the case
with factoring
Two-Factor System of Factoring
• There are usually four parties to a cross-border
factoring transactions
– Exporter (client)
– Importer (customer)
– Export Factor
– Import Factor
• Two factor system results in two separate but
inter-linked agreements
– Between exporter and export factor
– Between export factor import factor
Two-Factor System of Factoring
• Usually export and import factors belong to a
formal chain of factors with well-defined rules
governing the conduct of business.
• Import factor provides a link between export
factor and the importer and serves to solve the
international barriers like language problem,
legal formalities and so on. He also underwrites
customer trade credit risks, collects receivables
and transfers funds to the export factor in the
currency of the invoice
• Functions of factors are divided between export
factor and import factor
 Two-Factor System of Factoring
• Steps
– Exporter informs the export factor about the export of goods to a
particular import-client domiciled in a specified country.
– Export factor writes to import factor (domiciled in the country of the
importer) enquiring about the credit-worthiness, reputation and so on
of the importer
– On getting satisfactory information from the import factor, exporter
delivers the goods to the importer and the relevant invoices, bills of
lading and other supporting documents are delivered to the export
factor. Export receivables on a non-recourse basis are factored
– Export factor does credit checking, sales ledgering and collection to
the import factor
– Import factor collects the payment from the importer and effects
payments to the export factor on assignment/maturity/collection as per
the terms of assignment in the currency of the invoice
– Finally, the export factor makes payment to the exporter upon
assignment or maturity or collection depending upon the factoring
agreement between them
 Country A Country B
Goods and invoices – Stage I
Exporter Importer

Copy Invoice Stage II Payments

Stage VI

Prepayments Stage III

Statements Stage V

Export Factor Copy Invoices Stage IV Import Factor

Payments Stage VII

Payment of Commission Stage VIII

 Forfaiting
• Forfaiting is a form of financing of (export)
receivables pertaining to international trade. It
denotes the purchase of trade bills/promissory
notes by a bank/financial institution without
recourse to the seller. The purchase is in the
form of discounting the documents covering the
entire risk of non-payment in collection. All risks
and collection problems are fully the
responsibility of the purchaser (Forfaiter) who
pays cash to seller after discounting the
bills/notes.
 Forfaiting
• Steps
– In pursuance of a commercial contract between an
exporter and importer, the exporter sells and delivers the
goods to the importer on a deferred payment basis
– Importer draws a series of promissory notes in favour of
the exporter for payment including interest charge.
Alternatively, the exporter draws a series of bills which
are accepted by the importer. Bills/notes are sent to the
expoerter. The promissory notes/bills are guaranteed by
a bank which may not necessarily be the importer’s bank.
The guarantee by the bank is referred to as an AVAL
defined as an endorsement by a bank guaranteeing
payment by the buyer (importer)
 Forfaiting
• Steps
– Exporter enters into a fortaiting arrangement with a forfaiter
which is usually a reputed bank including exporter’s bank.
Exporter sells the availed notes/bills to the bank (forfaiter) at a
discount without recourse. The agreement provides for the basic
terms of the arrangement such as cost of forfaiting, margin to
cover risk, commitment charges, days of grace, fee to
compensate the forfaiter for loss of interest due to transfer and
payment delays, period of forfaiting contract, installment of
repayment, usually bi-annual instalment, rate of interest and so
on. The rate of interest or discount charged by the forfaiter
depends upon the terms of the note/bill, the currency in which it
is determined, credit rating of the avalling bank, country risk of
the importer etc
– Payment to forfaiter to the exporter of the face value of the
bill/note less discount
– Forfaiter may hold these notes/bills till maturity for payment by
the importer’s bank. Alternatively, he can securitize them and
sell the short-term paper in the secondary market as high-
yielding unsecured paper
 Forfaiting
• Summary
– Specific form of export trade finance
– Export receivables discounted – full value of export bill
considered
– Debt instruments most commonly used are bills of exchange and
promissory notes
– Payment in respect of export receivables which is further
evidenced by bills of exchange/promissory notes must be
guaranteed by importers bank. Usual form of guarantee is an
Aval
– Forefaiting is always without recourse
– Source of trade finance which enables exporters to get funds
from the institution called forfaiter on transferring the right to
recover the debts from the importer
 Factoring Vs Forfaiting
• Forfaiter discounts the entire value – 100 % finance
where as a Factor – 75-80%
• Avalling bank provides unconditional and irrevocable
guarantee – critical factor in forfaiting – in factoring
decision is based on credit rating of the exporter (non-
recourse)
• Forfaiting is pure financial arrangement – Factoring
includes ledger administration, collection, advise etc
• Factoring is short-term finance whereas forfaiting
finances notes/bills arising out of deferred credit
transactions spread over 3 years
• A factor does not guard against exchange rate
fluctuations, whereas forfaiter charges a premium for
such risk
• Thank you