Businesses often face the following Catch-22, especially when conducting international trade: they book a sale of finished products or services for which they will not receive payment until months later – but they need that payment in order to deliver the promised products or services. Perhaps the business needs funds to purchase manufacturing supplies, or to pay employees to perform the services. Regardless, during this Catch-22 period the business must continue to run and pay its bills, so it needs cash. This problem is exacerbated in international trade, when a business books sales across borders. International payments from foreign customers can take longer than payments from locals, and foreign suppliers sometimes want payment sooner.
Export Financing Comes to the Rescue
But the international trade finance industry has evolved export financing methods that alleviate these cash flow issues and unlock the value of a business’ accounts receivables or trade invoices. Two common methods are referred to as factoring and forfaiting. This article looks at each method and explores the differences between them.
International Trade Financing Through Factoring
Factoring, sometimes called debtor financing or receivables factoring, is more common for domestic trade financing but also is used for international trade finance. Factoring is a process by which a business sells to a financial institution the value of accounts receivables for which it has not yet received payment. To obtain the cash it needs right away, the business is willing to sell the value of those accounts receivable (generally due within 90 days) to the financial institution (commonly referred to as the “factor”) at a discount, creating the opportunity for the factor to profit.1 The discount is usually between 10 and 20 percent. For example, if the accounts receivable are valued at US$100,000, the business might sell them to the factor for US$80,000. The business is willing to forgo 20 percent of its accounts receivable value in order to obtain US$80,000 today to help keep the business running, instead of US$100,000 some months in the future. The factor buys the promised value of those accounts receivable for only US$80,000 but must wait the few months necessary to receive that full value, including a gross profit of US$20,000. Notably, factoring can be with recourse or non-recourse. An arrangement with recourse means that the factor may seek compensation from the business if the accounts receivable are not paid in full. Conversely, if it is without recourse, the factor must absorb the loss without possibility of compensation from the business.2
International Trade Financing Through Forfaiting
Though similar to factoring, forfaiting is a type of export financing used only for international trade. In forfaiting, an exporter sells its claim to trade receivables to a financial institution (the “forfaiter”) and receives payment immediately. The time frame for forfaiting is usually longer, several months to as long as several years, in some instances. Although forfaiters also demand a discount, the exporter typically can obtain 100 percent of the value of its trade receivable by incorporating the cost of the discount into its selling price.3 Therefore, in forfaiting, the exporter receives the full value immediately in cash, helping its business to keep running. In addition, the forfaiter assumes both the promise of payment as well as the risk associated with a potential failure to be paid, though it generally requires some form of guarantee from the buyer. Nonetheless, forfaiting is conducted without recourse, so that if the buyer fails to pay the invoice the forfaiter must bear the loss without the ability to request that the exporter defray the costs.4
Key Differences Between Factoring and Forfaiting
There are a few key differences to keep in mind between factoring and forfaiting. Factoring is used in both domestic and international trade, whereas forfaiting is only used in international trade financing. Letters of credit are not involved in factoring, but they are part of the forfaiting process. Factoring generally only provides 80 to 90 percent of the amount of the accounts receivable, but forfaiting can provide up to 100 percent of the amount of the invoices. Another point to bear in mind is that factoring involves accounts receivables, whereas forfaiting deals with negotiable instruments (such as bills of lading, promissory notes, etc.). Because forfaiting is based on negotiable instruments, there is a secondary market for forfaiting in which those instruments can be bought and sold, thus increasing the liquidity of forfaiting.5
Factoring and forfaiting are similar yet different. Businesses involved in international trade will likely encounter forfaiting as a trade financing tool. It is important to understand the costs associated with both factoring and forfaiting, as well as the responsibilities which are (and are not) assigned with each. Both factoring and forfaiting can be useful tools for businesses, provided they understand the pros and cons of each.