What is Forfaiting?
Forfaiting is a kind of international trade finance wherein export bills receivables are discounted, with which the exporters can get instant cash by selling their receivables. ‘Forfait’ is a French word which refers to ‘relinquishing a right’.
Therefore, in financing, ‘forfaiting’ implies giving up of the right to receivables, which are due at a future date, by the exporter to get quick cash at a discount. Further, the purchaser, i.e. forfaiter, bears all the risks and responsibilities as to the collection or non-payment of the bills or notes. The forfaiter is the third party to the transaction.
So, the exporter does not have any interest in the transaction further. Hence, the forfaiter receives the payments in future.
Table of Contents
Salient Features of Forfaiting
Upcoming points will discuss the salient features of forfaiting:
- In forfaiting, credit is advanced to the importer of capital goods for a certain period.
- The amount of payment is receivable in any convertible currency.
- The importer’s bank gives the letter of credit or bank guarantee.
- Finance is provided on a fixed or floating interest rate.
The forfaiter can be an individual or an entity, like a bank or a financial institution. The risks associated with the forfaiting are credit risk, transfer risk, foreign exchange rate risk or interest rate changes.
Moreover, it involves buying of international trade receivables such as the bill of exchange or promissory notes at a discount, on a 100% without recourse basis. This means that the seller (client) is eligible for complete credit protection, and the exporter has no liability if the importer defaults on the payment.
In addition, all the segments of the services, such as short-term finance, and administration of sales ledger, are available to the seller of the receivables.
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Forfaiting Process
When the exporter receives an export order from the importer, he/she approaches the forfaiter with necessary details like the importer’s country, type of goods, the value of goods, shipment date (expected), terms and conditions of repayment, etc.
The exporter expects a commitment to whether the forfaiter will allow credit or not. And if the forfaiter allows the same, what amount will it cost?
Based on the risk involved in the transaction, the forfaiter states the cost involved. However, if a bank or financial institution takes guarantees the importer’s obligation, the cost involved will be less. Now, we will discuss the entire process in detail when the importer’s obligation is guaranteed by the bank:
Steps Involved in the process of Forfaiting
- The exporter (seller) sells goods to the importer (buyer) on the basis of deferred payment. This amount of payment is spread over a period of three to five years.
- The importer draws a series of promissory notes in favour of the exporter for the amount that requires payment in future. It includes the amount of interest.
- Further, the promissory notes issued are guaranteed by a recognized international bank, often an importer’s banker. The guaranteeing bank assures that it covers the failure in payment of the buyer, if any.
- The exporter sells the notes so availed to the forfaiter (exporter’s banker) at a discount on a non-recourse basis to the seller.
- Now, when the forfaiter buys those notes, he can hold these notes until it gets mature. Alternatively, he can sell them to the investor’s group, who may be interested in buying an unsecured note having high-yielding potential or freely trade the debt instrument in the secondary market.
- The unconditional trade bills and notes hold legal enforceability. It ensures security to the forfaiter or next buyer of the instrument. The maturity of these instruments may lie between one month to ten years.
Advantages
- Forfaiting ensures immediate cash to the exporter, who gets protection from the risk of non-payment by the importer, as well as it eliminates collection costs.
- It is a way of earning for the commercial bank, which purchases the instrument yielding a high return. Further, it can earn a good amount when the value of the currency appreciates.
- Due to the involvement of the banks of both exporter and importer, the risk becomes very low.
- Forfaiting makes the transaction easy by converting the credit sale into a cash sale.
- It is flexible in nature. This implies that the forfaiter can customize the offering according to the requirement of the seller of the capital goods. Also, it can be changed to several international transactions.
Disadvantages
- There is a list of specific currencies which are considered for forfaiting. This is because they possess international liquidity.
- Forfaiting reduces the risk for exporters. However, it is more expensive as compared to the basic financing provided by banks or financial institutions, which results in higher export costs.
- The importer bears the higher export cost, which the standard pricing covers.
- Not all the transactions can avail the forfaiting facility. Meaning that transactions more than equal to a definite sum are eligible for forfaiting.
Wrap Up
Above all, forfaiting converts the supplier’s credit granted to the importer into cash transactions to protect him in full from all the risks involved with selling goods abroad on a credit basis.