STUDY NOTES

M.Com. Semester-IV

Subject: Financial Services

Chapter: Factoring and Forfaiting

Prepared by: Dr. Sukumar Pal

Associate Professor in Commerce

Sree Chaitanya Mahavidyalaya

Factoring and Forfaiting

Introduction

In India due to economic liberalisation & free trade policy the financial service sector is developing at a

faster rate. Financial institutions try to extend their axis trace to trading community through book debt financing.

It is no denying the fact that cash is a vital thing for any business concern. But usually there is a significant time

gap between sale of goods/services and receipt of cash out of such sale. The outstanding amount i.e. ‘Debtors’ or

‘Accounts Receivables’ get locked up for a period that depends on the contractual credit period allowed to the

buyers and are shown as ‘Current Assets’ in the balance sheets of the sellers. But faster realisation of accounts

receivables can enable a business concern to put the cash to more productive uses. So, business concerns have

always been on the lookout for selling the accounts receivables for cash, even at a discount. Such a thing

becomes possible through a financial service known as Factoring.

Factoring is an arrangement in which the receivables arising out of sale of goods/services to a debtor

(called ‘customer’) by a business concern (called ‘client’) are purchased by/sold to a financial institution/banker

(called ‘factor’) as a result of which the title to the goods represented by the said receivables passes on to the

factor in consideration of advance to the seller. The factor then becomes responsible for all credit control, sales

accounting and debt collection from the buyers. By obtaining payment of the invoices immediately from the

factor, usually up to 80% of their value, without having to wait until the buyer makes payment, the client’s cash

flow is improved.

Factoring is not a loan. With factoring there is neither any interest to pay, nor principal to repay. No

liability will appear on a concern’s balance sheet due to its factoring. Factoring involves an outright sale of the

receivables of a firm by another firm specialising in the management of trade credit, called factor. A business

concern simply sells one of its assets (‘Accounts Receivables’) for an agreed upon ‘fee’ to obtain a more liquid

asset (cash), thus self-financing its own growth with debt-free funding.

Factoring-Meaning & Definition

A financial service, whereby an institution called the ‘Factor’, undertakes the task of realizing accounts

receivables such as book debts, bills receivables, and managing sundry debts and sales registers of commercial

and trading firms in the capacity of an agent, for a commission, is known as ‘Factoring’. Factoring, as a fund-

based financial service, provides resources to finance receivables, besides facilitating the collection of

receivables.

V. A. Avadhani defines, “factoring is a service of financial nature involving the conversion of credit bills

into cash”.

C.S, Kalyansundaram, in his report (1988) submitted to the RBI defines factoring as “a continuing

arrangement under which a financing institution assumes the credit and collection functions for its client,

purchases receivables as they arise (with or without recourse for credit losses, ie., the customer’s financial

inability to pay), maintains the sales ledger, attend to other book-keeping duties relating to such accounts, and

performs other auxiliary functions.”

SBI Factors and Commercial Services Pvt. Ltd. defines, ‘Factoring is a continuing arrangement between a

financial institution (the factor) and a business concern (the client) selling goods or services to trade customers

(the customer) whereby the factor purchases the client’s accounts receivables/book debts either with or without

recourse to the client and in relation thereto controls the credit extended to the customers and administers the

sales ledger.

In the UNIDROIT Convention held in Ottawa on May, 1988, it came out with a definition according to

which Factoring means “a contract concluded between one party (the supplier) and another party (the factor)

pursuant to which:

(a) The supplier may or will assign to the factor receivables arising from contracts of sale of goods made

between the supplier and its customers (debtors) other than those for the sale of goods bought primarily for

their personal, family or household use;

(b) The factor is to perform at least two of the following functions:

-Finance for the supplier, including loans and advances payments;

-Maintenance of accounts (ledgering) relating to the receivables;

-Collection of receivables;

-Protection against default in payment by debtors,

(c) Notice of the assignment of the receivables is to be given to debtors.”

Genesis

The word factor has been derived from the Latin word ‘factare’ means ‘to make or to do’ or ‘to get things

done’. Factoring originated in countries like USA, U. K., France, etc. where specialised financial institutions

were established to assist firms in meeting their working capital requirements by purchasing their receivables.

Factoring was a well-developed activity in England in the 14th century, where it evolved with the growth of the

wool industry. The job of the factors centred on their functions as sales agents, or commission merchants, for

textile mills. In addition to that Factors also assumed some critical financial functions on behalf of the mills.

They offered credit advice on how much to sell on account to potential customers. They also guaranteed

payments to the mills, assuming full responsibility for the creditworthiness of the mills’ customers. Thus, in

essence, factoring was fully reflected economically in the financial component of the factoring business as is

existed 600 years ago. The difference between today and 600 years ago is that the sales or ‘agenting’, component

has been purged from the factoring relationship. But factoring as it is typically practised in both developed and

developing economies, can still be viewed as a bundle of activities.

Factoring is of a recent origin in the Indian context. In 1988, the Reserve Bank of India (RBI) constituted

a High Powered Committee to examine the scope for offering factoring services in the country. In 1989, the

committee submitted its report strongly recommending the case for setting up factoring subsidiaries. Following

the announcement of the guidelines, the State Bank of India and Canara Bank have set-up their factoring

subsidiaries – SBI Factors & Commercial Services Limited and Can Bank Factors Limited.

Mechanism

Under the factoring arrangement, the seller does not maintain a credit or collection department. The job,

instead is handed over to a specialised agency, called the ‘Factor’. After each sale, a copy of the invoice and

delivery challan, the agreement and other related papers are handed over to the Factor. The Factor, in turn,

receives payment from the buyer on the due date as agreed, whereby the buyer is reminded of the due date

payment account for collection. The Factor remits the money collected to the seller after deducting and adjusting

its own service charges at the agreed rate. Thereafter, the seller closes all transactions with the Factor. The seller

passes on the papers to the Factor for recovery of the amount. The following steps show the mechanism of the

factoring process:

1. The seller or client sells its product or service to a customer and issues an invoice for the value of the goods

or service.

2. A copy of the invoice and a cover sheet is submitted (by fax or otherwise) to the Factor for approval.

3. The factor collects credit history and financial information from the buyer (customer) for overall credit

assessment.

4. The factor makes a decision on the individual buyer’s credit, based on each buyer’s financial information

and other relevant data.

5. The factor informs the client of the guarantee decision and issues a guarantee number for each purchase

order.

6. The client delivers the goods to the buyer.

7. The factor deposits the cash advance (usually 70-80%, sometimes up to 90%) to the client’s bank account

via electronic deposit or otherwise. This is the first of two payments the client receives when factoring an

invoice.

8. The client sends the factor an assignment of accounts along with copies of the invoices and the delivery

documents to the factor. The client sends the invoice to the buyer. The invoice should have instructions

informing the buyer to pay the factor.

9. The buyer pays the factor for the invoice on around the due date.

10. When full payment is received, the factor withholds a small factoring service fee, and returns the balance, or

reserve (the amount not advanced), back to the client. The reserve is the second payment the client receives

from the factor for the invoice.

Figure – 1: Process of Factoring

(1) Credit sale of goods

(2) Notifies the customer

(3) Submit invoice copy

(4) Follows up for the payment

(5) Advance Payment up to 80%

(6) Customer remits

(7) Pays the balance amount the final payment

Source: TF Factoring and Forfaiting ICFAI, Pg-3

Sl. No. Description

1 Client concludes a credit sale with the customer.

2 Client sells the customer’s account to the factor and notifies the customer.

3 Factor makes a part payment (advance) against the account purchased after adjusting for

commission and interest on the advance.

4 Factor maintains the customer’s account and follows up for payment.

5 Customer remits the amount due to the factor

6 Factor makes the final payment to the client when the account is collected or on a guaranteed

payment date.

Functions of a Factor A factor offers the following services:

(i) Collection facility of accounts receivables

(ii) Sales-ledger administration

(iii) Credit protection

(iv) Short-term funding

(v) Advisory services.

Collection facility of accounts receivables

Collection of receivables can be considered as the most important function of a factor for two reasons.

First, the clients’ receivables are the only productive assets of the factor. Therefore, a lax collection program will

impair the profitability of the factor’s operations. Second, any incorrect handling of the collection activity can

Client Customer

Factor

prejudice the relationship between the client and his customer which in turn is detrimental to the interests of both

the client and the customer – the client loses potential business and the factor loses potential commission.

A typical collection program of the factor consists of the following steps:

1. The factor sends statements of accounts to the customers prior to the due dates and routine collection letters

around the due dates.

2. If a debt reaches a certain point in being overdue, the factor initiates personal collection efforts which can be

in the form of a personal letter, telephonic reminder or visit to the premises of the customer.

3. The factor resorts to legal action if the debt is irrecoverable by other means.

Sales-Ledger Administration

The factor maintains a sales ledger for each client. The ledger is maintained under one of the following

methods:

(i) Open-item method

(ii) Balancing method.

Under the open-item method, each receipt is matched against the specific invoice and therefore the customer’s

account clearly reflects the various open invoices which are outstanding on any given date. Under the Balancing

method, the transactions are recorded in the chronological order, the customer’s account is balanced periodically

and the net amount outstanding is carried forward. When accounts are maintained manually the balancing

method is easy to operate. However, the open-item method permits better control because collection efforts can

be focused on identifiable debts. Since most of the factors employ mechanized accounting systems for sales-

ledger maintenance, the open-item method is widely followed. In addition to the sales-ledger, the factor also

maintains a customer-wise record of payments spread over a period of time so that any change in the pattern of

payment can be easily picked up.

Credit Protection

When receivables are purchased under a non-recourse factoring arrangement, the factor establishes a line

of credit or defines the credit limit up to which the client can sell to the customer. The credit line or limit

approved for each customer will depend upon the customer’s financial position, his past payment record and the

value of goods sold by the client to the customer. Operationally, the monitoring of the credit utilized by a

customer poses some problem to the client because he has turned over the ledgering work to the factor. To

overcome this difficulty, some factors define the monthly sales turnover for each customer which will be

automatically covered by the approved credit limit.

For example, if the approved credit limit for a customer is Rs.3 lakh and the average collection period is say 45

days, sales up to Rs.2 lakh (3 x30

45)per month will be automatically covered. Instead of setting a limit on the

monthly sales turnover, some factors provide periodic reports to their clients on customer-wise outstanding and

ageing schedules to enable the client to assess the extent of credit utilization before any major sale is made.

To assess the creditworthiness of a customer, the factor relies on a number of sources. They include:

i. Credit ratings and reports

ii. Bank reports and Trade references

iii. Analysis of financial statements

iv. Prior collection experience

v. Customer visits.

Short-term Funding

A factor usually pays for a part of the debts purchased immediately and charges interest on the part

payment made for the period between the date of purchase and the collection date/guaranteed payment date. The

factor does not provide hundred percent finance and maintains a margin called the factor reserve. The factor

reserve is a safety net for protecting the factor against contingencies such as sales returns, disputed debts, etc.

70% to 80% of the assigned debts are usually granted as advances to the client by the factor. The factor is usually

wary of financing recourse receivables because he does not participate in the credit-granting decision. Therefore,

he prefers to purchase such receivables with the clear understanding that no advance payment will be made

against such receivables. In the case of ‘with recourse factoring’, the advance provided by the factor would have

to be refunded by the client in the event of non-payment by the buyer. In the case of ‘without recourse (non-

recourse) factoring’ there would be no question of the advance being returned to the factor.

Advisory Services

These services are spin-offs of the close relationship that develops between a factor and the client. Given the

specialized knowledge of the factor about the market(s) in which the client operates, he is in a better position to

advise the client on

the customers’ perceptions of the firm’s products,

changes required for in the marketing strategies,

emerging trends and ways of responding to these trends,

Audit of the process adopted for invoicing, delivery and sales return, etc.

In addition, the factor can help the client in areas which fall outside the purview of the factoring services. For

example, if the factoring organization happens to be the subsidiary of a commercial bank, it may provide an

introduction to the credit department of the bank or to the other subsidiaries of the bank which are involved in

providing other financial services like leasing, hire purchase or merchant banking. Given the in-depth knowledge

of the factor about the character and capacity of the client, the recommendation or introduction provided by the

factor considerably strengthens the client’s position in dealing with these financial intermediaries.

Factoring Fees

The company that provides the factoring facility normally makes two main charges which are often as follows:

(a) Administration Charge (or service Charge)

This is a fee for managing the client’s credit sales ledger if the client is factoring or for maintain the client’s

account if the client is invoice discounting. This is expressed as a percentage of the value of the sales

invoices that the client raises. The fee typically ranges from 0.2% to 3.5%.

(b) Discount Charge

This is a charge, similar to interest, that is levied in respect of the funds that the client actually uses. It is

normally between 1.0% and 3.5% over bank base rate.

In addition to the above, there may be additional charge that factoring company makes.

Forms of Factoring

Depending upon the features built into the factoring transaction, there can be different forms of factoring

arrangements. These are as follows:

a. Recourse factoring

b. Non-recourse factoring

c. Maturity factoring

d. Advance factoring

e. Invoice discounting

f. Full factoring

g. Bank participation factoring

h. Disclosed and undisclosed factoring

i. Supplier guarantee factoring

j. Domestic and Export/Cross-border/International factoring.

The following features are, of course, common to most of the factoring arrangements:

(i) the factor is responsible for collection of receivables;

(ii) the factor maintains the sales ledger of the client.

The additional feature(s) built into the different types of factoring arrangements are discussed here:

Recourse Factoring

The factor purchases the receivables on the condition that the loss arising on account of irrecoverable

receivables will be borne by the client. For example, assume that a factor has advanced an amount of Rs.2.4 lakh

against a receivable of Rs.3 lakh which turns out to be irrecoverable. Under a recourse factoring arrangement, the

factor can recover the sum of Rs.2.4 lakh from the client. Put differently, under a recourse factoring arrangement,

the factor has recourse to the client if the debt purchased turns out to be irrecoverable.

Non-Recourse Factoring

As the name implies, the factor has no recourse to the client if the debt purchased turns out to be

irrecoverable. Since the factor bears the losses arising on account of irrecoverable debts (receivables), the factor

charges a higher commission (the additional commission is called the del credere commission). Also, the factor

participates actively in the credit-granting process and decides/approves the credit lines extended to the

customers of the client. While non-recourse factoring is the most common form of factoring in countries like the

USA and the UK, in the Indian context, factoring is done with recourse to the client.

Maturity Factoring

Under this type of factoring arrangement, the factor does not make any advance payment. The factor pays

the client either on a guaranteed payment date or on the date of collection. The guaranteed payment date is

usually fixed taking into account the previous ledger experience of the client and a period for slow collection

after the due date of the invoice.

Advance Factoring

Under this arrangement, the factor provides an advance varying between 75-85 percent of the value of

receivables factored. The balance is paid upon collection or on the guaranteed payment date. As we have already

seen, the factor charges interest from the date on which advance payment is made to the date of actual collection

or the guaranteed payment date. The rate of interest is usually determined depending upon (i) the prevailing

short-term rate of interest; and (ii) the client’s financial standing and (iii) volume of turnover.

Full Factoring

A factoring arrangement which combines the features of non-recourse and advance factoring

arrangements is called Full Factoring or Old Line Factoring. Put differently, full factoring provides the entire

spectrum of services – collection,credit, protection, sales-ledger administration and short-term finance.

Bank Participation Factoring

This arrangement can be viewed as an extension of advance factoring. Under this arrangement, a

commercial bank participates in the transaction by providing an advance to the client against the reserves

maintained by the factor. For example, assume that a factor has advanced 80 percent of the value of factored

receivables and the commercial bank provides an advance limited to 50 percent of the factor reserves. The client

is required to fund only 10 percent of the investment in receivables, the balance 90 percent being provided by the

factor and the commercial bank.

Disclosed and undisclosed factoring

Disclosed factoring is the arrangement under which the exporter enters into a factoring agreement with the

financial house and assigns the benefit of the debts created by the sale transaction to them. The importer is then

notified and effects payment to the factor. The arrangement is usually on a non-recourse basis. This means that

the factor cannot claim the assigned funds from the exporter if the importer fails to pay, in other words, he

assumes the credit risk in the transaction. Those debts that are not approved by the factor are assigned on a

recourse basis, so he can claim against the exporter in case of any default of the importer. Recourse factoring is

more accurately described as invoice discounting. Factoring arrangements are usually made on a whole turnover

basis. This arrangement connotes an obligation of the exporter to offer all his receivables to the factor who

receives a commission undisclosed factoring, which is usually undertaken on a recourse basis and does not

involve the importer. The agreement is made between the factor and the exporter and the importer remains bound

to pay as agreed under the sales contract. In receipt of payment, the exporter holds the funds in a separate bank

account as trustee for the factor.

Supplier Guarantee Factoring

This arrangement was developed by the American factors primarily to help their importers/distributors

involved in executing import orders on behalf of their customers. The typical steps involved are as follows:

i. The customer places an import order with the distributor.

ii. The distributor seeks the approval of the factor for extending credit to the customer.

iii. On receiving the credit approval from the factor, the distributor makes arrangements for shipping the supplies

directly to the customer.

iv. The factor guarantees payment to the foreign supplier in respect of the specific shipment. Upon shipment, he

credits the account of the distributor and debits the account of the customer for an amount equal to the invoice

value of the goods shipped plus distributor’s commission.

v.Instead of making an advance payment to the distributor against the customer’s account that has been factored,

the factor pays the supplier directly for the invoice value of the goods shipped.

vi. The factor follows up with the customer, collects the amount due and makes the final payment to the

distributor after deducting his commission and guarantee charges.

Thus, apart from offering the usual services, the factor guarantees payment to the supplier on behalf of his client

(the distributor) thereby engendering greater confidence in supplier-distributor dealings.

Domestic and Export/Cross-border/International factoring

The mechanics of Cross-border Factoring (also referred to as an international factoring or export

factoring) is similar to domestic factoring except that there are usually four parties to the transaction – exporter,

export factor, import factor and importer. Under this system of factoring referred to as the two factor system of

factoring, the exporter (the client) enters into a factoring agreement with the export factor domiciled in his

country and assigns to him export receivables as and when they arise. The payments against the factored debts

are made exactly in the same way as under a domestic factoring facility. If the sale value is denominated in the

currency of the importer’s country, the factor usually covers the exchange risk associated with the remittances.

The export factor enters into an arrangement with a factor based in the country where the importer resides

(import factor) and contracts out the tasks of credit checking, sales ledgering and collection for an agreed fee.

The debt is usually not assigned to the import factor. The relationship between the import factor and the importer

(the customer) is clarified by a notation on the sales invoice that the payment is to be made directly to the import

factor. The import factor collects the amount from the customer and remits it to the export factor.

International factoring

The UNIDROIT convention defines international factoring as “an agreement between an exporter and factor

whereby the factor purchases the trade debt from the exporter and provides the services such as finance,

maintenance of sales ledger, collection of debts, and protection against credit risks”. There are various forms of

international factoring. It basically depends on the exporters’ needs and cost bearing capacity, and security to the

factors. These are “Two factor system”, “Direct export factoring”, Direct Import Factoring” and “Back to Back

factoring”. Among these types the two factor system gives some added benefits.

(a) The two factor system

An international factoring transaction involves a number of elements that differentiate it from a domestic

factoring transaction. Possibly the most important differentiations are the different languages of the parties to

the sales contract and the difficulty in assessing the credit standing of a foreign party. As an answer to these

considerations the two-factor system was developed. This entails the use of two factors, one in each country,

dealing with the exporter and the importer respectively. The export factor on obtaining the information from

the exporter on the type of his business and the proposed transaction will contact the import factor

designated by the importer and agree with the terms of the deal. The importer advances funds to the import

factor who then transmits them to the export factor, minus his charges. In the two-factor system the import

factor and the importer do not come into direct contact. The system involves three agreements, one between

the exporter and the importer, one between the export factor and the exporter and one between the factors

themselves. It is important to bear in mind that the import factor’s obligations are to the export factor alone

and they include determining the importer’s credit rating and the actual collection of the debts. The import

factor assumes the credit risk in relation to approve debts and is responsible for the transfer of funds to the

export factor. On the other hand, the export factor is responsible to the import factor for the acceptance of

any recourse. The two-factor system is supported by the existence of chains of correspondent factors. These

are established for the purpose of facilitating the cooperation between the import and the export factors by

the development of common rules and accounting procedures. There are members of factoring chains in

most major trading nations. Some of them restrict their membership to one factor per country (Closed

Chains), while others are open to the participation of multiple factors in the same country (Factors Chain

International). The two-factor system has various advantages. The main ones concentrate around efficiency

and speed. The import factor is in a better situation to assess the credit capabilities of the importer and

communicate effectively with him. He knows the legal and business environment in the country and is in a

position to take swift action in case of any default. It facilitates the international trade by speeding up the

circulation of funds. The speedier the flow of funds from the buyer to the seller, the smaller the risk of

exchange rate fluctuations between the date of shipment and the date of payment. Finally, the use of this

system can help in reducing the exchange risk involved in international trade transaction.

The use of the import factor alleviates the pressure on the export factor and streamlines the procedure. The same

elements make the system preferable to the exporter who is sparing the inconvenience of dealing with a

foreign factor. Further, there is the possibility of the client receiving lower discount charges if the import

factor makes payments at the rate of discount charge in his country (if these are lower than the ones in the

exporter’s home jurisdiction).

Organizations facilitating the “Two Factor System”

There are different institutions currently working in the world to support the mechanism. Among those two

organizations, the prominent ones are the IFG (International Factors Group) and the FCI(Factors Chain

International). These are associations of factoring organizations or factors from all over the world. The

International Factors Group was founded in 1963 as the first international association of factoring

companies. The original mission of IFG was to help factoring companies to conduct cross-border business

acting as correspondents for each other. This is still the core activity of IFG today FCI is a global network of

leading factoring companies, whose common aim is to facilitate international trade through factoring and

related financial services. FCI's mission is to become the worldwide standard for international factoring.

Detailed Steps in International Factoring (Two Factor Model)

1.The importer places the order for purchase of goods with the exporter

2.The exporter approaches the export factor(in the exporter’s country)for limit approval on the importer. Export

Factor in turn requests the import factor in the Importer's country for the arrangement

3.The import factor assesses the importer and approves/rejects the arrangement and accordingly Conveys to the

export factor

4.Exporter is informed of the commencement or otherwise of the factoring arrangement

5.The exporter delivers the goods to the importer

6.Exporter produces the documents to the export factor

7.The export factor disburses funds to the exporter upto the prepayment amount and forwards the documents to

the Import factor as well as the Importer

8.On the due date of the invoice, the Importer pays the Import Factor, who in turn remits the payment to the

export factor.

9.The exporter receives the balance payment from the export factor.

(b) Single Factoring

With a view to obviating the constraints in the two factor system, a variation by way of single factoring has

been introduced by some of the factoring companies, primarily those who are part of the Factors Chain

International (FCI) group. Under this system,, a special agreement is signed between two factoring

companies in the exporting and importing countries on conditions for single factoring, whereas in the two

factor system, the credit cover is provided by the import factor. However, prepayment, book keeping and

collection responsibilities, prima facie, remain vested with the export factor. If the export factor is not in a

position to realise any debt within 60 days from the due date, he requests the importing counterpart to

undertake the collection responsibility, simultaneously informing the defaulting debtor about the assignment

of the debt to the latter. It is not the responsibility of the import factor to continue the collection endeavour

and initiate legal proceeding, if necessary. In case the debt remains outstanding for a period exceeding 90

days from the due date, owing to the financial inability of the importer, the import factor has to remit, by

virtue of his undertaking credit risk, the amount to the factor.

(c) Direct import and export factoring

Direct import factoring connotes the situation where the exporter assigns debts to a factor in the country of

the debtor. This is usually the case where there is a substantial volume of exports to a specific country. This

solution is a cheap and time efficient method of debt collection but it does not serve the aim of providing

finance to the exporter. The factor provides a debt collection service and does not enquire into the

creditworthiness of the importer. Prepayments are not possible because that would expose the factor to high

risks. Direct export factoring, on the other hand, does operate as an alternative to the two-factor system. In

this situation, the factor is appointed in the exporter’s own country and deals with all the aspects of the

factoring arrangement including the provision of financing and the assessment of the financial position of the

importer. This system is inexpensive and facilitates the communication between the exporter and the factor.

However, all the advantages of the two factor system relating to the import factor’s proximity to the importer

and his jurisdiction, can be listed here as disadvantages. Communication problems with the debtor, credit

risks and the occurrence of disputes are the most important problems.

(d) Back to back factoring

Back to back factoring is an arrangement most suitable for debts owed by the exclusive distributors of

products to their suppliers. The structure of the agreements is similar to the ones already considered with one

material difference. The exporter enters into a factoring agreement with the export factor that contact with

the import factor in the usual way. The difference lies in the existence of a separate factoring agreement

between the import factor and the distributor. Included in that arrangement is a right to set off credits arising

from the domestic sales of the distributor with his debts to the supplier. The fact that the goods have already

been sold to the third parties and thus the supplier cannot take a security interest over them to guarantee

repayment of the debts.

Invoice Discounting

Strictly speaking, this is not a form of factoring because it does not carry the service elements of

factoring. Under this arrangement, the factor provides a prepayment to the client against the purchase of book

debts and charges interest for the period spanning the date of pre-payment to the date of collection. The sales

ledger administration and collection are carried out by the client. The client provides the factor with periodical

reports on the value of unpaid invoices and the ageing schedule of debts. This facility is usually kept confidential

i.e., the customers (whose debts have been purchased by the factor) are not informed of the arrangement.

Therefore, this arrangement is also referred as ‘Confidential Factoring’. A variant of the invoice discounting is

the Protected Invoice Discounting arrangement where the factor bears the credit risk of the receivables

purchased. Put differently, the factor purchases the debts without recourse but does not offer the services of

sales-ledger administration and debt collection. Invoice discounting in general and protected invoice discounting

in particular are offered to clients with a sound financial position and with no serious problem of debt collection

and debt write-offs. If the invoice discounting facility is not confidential in nature, the customers of the client are

advised to make payment directly to the factor and this facility is referred to as ‘Bulk Factoring’. The need for

this facility arises when the factor finds that the client does not fulfill the criteria laid down for invoice

discounting and requires the security associated with direct payments from the customers. Bulk factoring offered

with a non-recourse feature is referred to as ‘Agency Factoring’ in some countries, because the client acts as an

agent of the factor in collecting the debts.

Advantages of Factoring Factoring is becoming popular all over the world on account of various services offered by the institutions

engaged in it. Factors render services ranging from bill discounting facilities offered by the commercial banks to

total takeover of administration of credit sales including maintenance of sales ledger, collection of accounts

receivables, credit control, protection from bad debts provision of finance and rendering of advisory services to

their clients. Thus factoring is a tool of receivables management employed to release the funds tied up in credit

extended to customers and to solve problems relating to collection, delays and defaults of the receivables. A firm

that enters into factoring agreement is benefited in a number of ways, some of the important benefits are outlined

below:

1. Cost Savings: Factoring allows for the elimination of trade discounts. Besides, it also helps in reduction of

administrative cost and burden, save on high bank charges and expenses, facilitating cost savings.

2. Reduction of time and money used for debt collection: The factors provides specialised services with

regard to sales ledger administration and credit control and relieves the client from the botheration of debt

collection and thus the client saves the management time, money and effort in collecting the receivables and

in sales ledger management. He can concentrate on the other major areas of his business and improve his

efficiency.

3. Increase the liquidity position of the business: The advance payments made by the factor to the client in

respect of the bills purchased increase his liquid resources. He is able to meet his liabilities as and when they

arise thus improving his credit standing position before suppliers, lenders and bankers.

4. Assessment of Customers’ creditworthiness: The client organisation can use the factor’s credit control

system to help assess the creditworthiness of new and existing customers. The factor’s assumption of credit

risk relieves him from the tension of bad debt losses. The client can take steps to reduce his reserve for bad

debts.

5. Competitive terms to offer: It provides flexibility to the company to decide about extending better

competitive terms to their customers.

6. Improvement of Cash Flow: The Company itself is in a better position to meet its commitments more

promptly due to improved cash flows.

7. Better purchase planning and availability of cash discount: Better purchase planning is possible.

Availability of cash helps the company to avail cash discounts on its purchases. It enables the company to

meet seasonal demands for cash whenever required.

8. Increase the Efficiency ratio: As it is an off balance sheet finance, thus it does not affect the financial

structure. This would help in boosting the efficiency ratios such as return on asset etc.

9. Acceleration of production cycle: With cash available for credit sales, client organisation’s liquidity will

improve and therefore, its production cycle will be accelerated.

10. Updated information flow: It ensures better management of receivables as factor firm is specialised agency

for the same. The factor carries out assessment of the client with regard to his financial, operational and

managerial capabilities whether his debts are collectable and viability of his operations. He also assesses the

debtor regarding the nature of business, vulnerability of his operations; and assesses the debtor regarding the

nature of business, vulnerability to seasonality, history of operations, the term of sales, the track record and

bank report available on the past history.

11. Enhancement of return: Factoring is considered attractive to users as it helps enhance return.

12. Freeing up working capital: Many companies have the majority of capital tied up in inventory. Accounts

receivable funding allows a company to free up capital tied up in inventory.

Limitations

The above listed advantages do not mean that the factoring operations are totally free from any limitation. The

attendant risk itself is of very high degree. Some of the main limitations of such transactions are listed below:

1. It may lead to over-confidence in the behaviour of the client resulting in over-trading or mismanagement.

2. The risk element in factoring gets accentuated due to possible fraudulent acts by the client in furnishing the

main instrument “invoice” to the factor. Invoicing against non-existent goods, pre-invoicing (i.e. invoicing

before physical dispatch of goods), duplicate-invoicing (i.e. making more than one invoice in respect of single

transaction) are some commonly found frauds in such operations, which had put many factors into difficulty

in late 50’s all over the world.

3. Lack of professionalism and competence, underdeveloped expertise, resistance to change etc. are some of the

problems which have made factoring services unpopular.

4. Rights of the factor resulting from purchase of trade debts are uncertain, not as strong as that in bills of

exchange and are subject to settlement of discounts, returns and allowances.

5. Small companies with lesser turnover, companies having high concentration on a few debtors, companies with

speculative business, companies selling a large number of products of various types to general public or

companies having large number of debtors for small amounts etc. may not be suitable for entering into

factoring contracts.

Factoring Vis-Á-Vis Bills Discounting

While factoring is of recent origin in the Indian context, most readers will be familiar with the bill

discounting arrangement offered by commercial banks and finance companies. The bill discounting arrangement

works as follows: The bill or the bill of exchange arises out of a credit sales transaction. The seller of the goods

(drawer) draws a bill on the buyer which may be payable on demand or after a usance period not exceeding

ninety days. The bill is accepted by the buyer (drawee) and/or by the buyer’s bank. Thereafter, the seller

approaches his bank or the bank of the buyer or a finance company to discount the bill.

The bank or the finance company discounting bills prefers to discount bills which are accepted by the

buyer under a letter of credit opened by the buyer’s bank referred to as L/C (Letter of Credit) backed bills as

opposed to bills which are not backed by L/Cs referred to as Clean Bills. The finance company discounts the bill

upfront. Put differently, the discount charge is payable in advance which means that the effective rate of interest

is higher than the quoted rate. The rate of discount varies from time to time depending upon the movements in

the short-term interest rate. The rate of discount applicable to clean bills is usually higher than the rate applicable

to backed bills.

Factoring Bill Discounting

1. In addition to the provision of finance, several

other services like maintenance of sales ledger,

advisory services, etc. are provided.

1. Finance alone is provided.

2. Trade Debts (receivables) are purchased by

Assignment.

2. Advances are made against bills.

3. Purchase of debt for consideration. 3. Security is provided.

4. Factor is the collector of receivables 4. Drawer (seller of the goods) is the collector of

receivables.

5. Whole turnover-bulk finance is provided. 5. Individual transaction oriented.

6. An all-time acceptance of notification is sufficient

for all future transactions.

6. The bill has to be accepted by drawee (buyer)

and/or by the buyer’s bank.

7. The factor undertakes to collect the bills of the

client.

7. The drawer undertakes the responsibility of

collecting the bills and remitting the proceeds to

financing agency.

8. Debts purchased for factoring cannot be

rediscounted, they can only be refinanced.

8. Bills discounted may be rediscounted several

times before the maturity. The last holder of the

bill receives the full amount of the bill.

9. Factoring may be with or without recourse. 9. Bill discounting is always with recourse, i.e. in

case of default the client will have to make good

the loss.

10. In factoring, bulk finance is provided against

several unpaid trade generated invoices in

batches. It follows the principle of ‘whole

turnover’.

10. Bill financing is individual transaction oriented,

i.e., each bill is separately assessed on its merits

and discounted.

11. In full factoring, services facility is ‘Off Balance

Sheet’ arrangement, as the client company

11. Bill finance is always ‘In Balance Sheet’

financing, i.e., both the amounts of receivables

completed his double entry accounting by

crediting the factor for consideration value.

and bank credit are reflected in the balance sheet

of the client as current assets and current

liabilities respectively. This is because of the

‘with recourse’ nature of the facility, i.e., the

bank reserving the right to fall back upon the

client (the drawer of the bill) in the case of

dishonour of the same by the acceptor or the

drawee.

12. Factoring services like ‘undisclosed factoring’ is

confidential in nature, i.e., the debtors are not

aware of the arrangements. Thus, the large

industrial houses availing such facility can

successfully claim of running business of their

own without any outside financial support.

12. The drawee or the acceptor of the bills is in full

knowledge of the bank’s charge on the

receivables arising from the sale of goods and

services.

13. The factor reserves the right to give notice in the

case of risk.

13. Notice of assignment of bills is not usually given

to the customers.

14. Since the factor is the owner of debt, the question

of registration of charge does not arise.

14. Charge of the lender (bank) can be registered

with the Registrar of Companies.

15. No stamp duty is charged on the invoices. No

charge other than the usual finance and service

charge.

15. Stamp duty is charged on certain usance bills

together with bank charges. It proves very

expensive.

16. Grace periods are far more generous. 16. Grace period for payment is usually 3 days.

Factoring in India and Role of Reserve Bank

Factoring service, which is perceived as complimentary to bank finance, enables the availability of much

needed working capital finance for the small and medium scale industries especially those that have good quality

receivables but may not be in a position to obtain enough bank finance due to lack of collateral or credit profile.

By having a continuous business relationship with the factoring companies, small traders, industries and

exporters get the advantage of improving the cash flow and liquidity of their business as also the facility of

availing ancillary services like sales ledger accounting, collection of receivables, credit protection etc. Factoring

helps them to free their resources and have a one-stop arrangement for various business needs enabling smooth

running of their business.

The Kalyanasundaram Study Group set up by the Reserve Bank of India in January 1988 to examine the

feasibility and mechanics of starting factoring organisations in the country paved the way for provision of

domestic factoring services in India. The Banking Regulation Act, 1949 was amended to include factoring as a

form of business in which the banks might engage. Reserve Bank of India issued guidelines permitting the banks

to set up separate subsidiaries or invest in factoring companies jointly with other banks. However, it was

generally felt that absence of Factoring Law was one of the major impediments in the growth of factoring

business of the country including the heavy stamp duty over assignment deed, ambiguity in the legal rights of

Factors in respect of receivables etc.

Government of India enacted the Factoring Act, 2011 to bring in the much-needed legal framework for

the factoring business in the country. It has provided definitions for the terms factoring, factor, receivables and

assignment. The Act also specifies that any entity conducting factoring business would need to be registered with

RBI as NBFCs; while exempting banks, government companies and corporations established under an Act of

Parliament, from the requirement of registration with RBI for conducting factoring business. The Act, thus, gave

clarity to the activity of assignment of receivables and granted exemption from stamp duty on documents

executed for the purpose of assignment of receivables in favour of Factors thereby making the business more

viable. The Act also envisages that all transactions of assignment of receivables shall be registered with the

Central Registry established under the SARFAESI Act, 2002 to reduce the possibility of frauds and for

strengthening the due diligence process for the clients.

The Act has given powers to the Reserve Bank to stipulate conditions for ‘principal business’ of a Factor

as also powers to give directions and collect information from factors. Subsequent to the passing of the Act, the

Reserve Bank has created a separate category of NBFCs viz; NBFC-Factors and issued directions for their

regulation. The prudential norms as applicable to NBFCs engaged in lending business, has also been extended to

the NBFC-Factors. Further, the RBI also regulates bank finance to factoring companies and the factoring

business conducted by banks.

Challenges Faced by Factoring Sector

Though the enactment of the Factoring Regulation Act has potentially removed all the major impediments that

the factoring sector faced in the country, nevertheless, the sector has few other items on its wish list, the primary

among which are introduction of credit insurance in the factoring business and extending the scope of

SARFAESI Act to cover NBFCs for speedy enforcement of security interest. As regards credit insurance, the

Finance Minister, in the Union Budget 2013-14, has made an announcement for setting up a Credit Guarantee

Fund with SIDBI for factoring, with an Rs 5 billion corpus. As far as extension of the provisions of the

SARFAESI Act to NBFC is concerned, the final call rests with the Government of India. Low penetration of

factoring business in the country remains a challenge, which could be because of lack of awareness among the

users. With the necessary law now in place, sincere attempts need to be made by the industry through its

associations and other fora for articulating the benefits of factoring as not just an alternative source of finance but

also an avenue for providing a bouquet of financial services vis-à-vis traditional finance, to small scale

industries. They should be able to identify the untapped potential clientele, especially in various SME industry

sectors, and create awareness on how the higher cost of factoring vis-à-vis the traditional finance is justifiable

and cost effective for the businesses in the end. Factoring companies should also constantly endeavour to

upgrade their expertise on both technological front as also on the operational level for offering cost effective

services to their clientele.

Role of Factoring in Indian SMEs

Small and Medium Enterprises (SMEs) in India have seen exponential growth over the last decade. According to

the latest reports by the SME Chamber of Commerce and the Ministry of Micro, Small and Medium Enterprises,

India currently has more than 48 million SMEs. These SMEs contribute more than 45% of India’s industrial

output, 40% of the country’s total exports. Yet, these SMEs continue to struggle on multiple accounts. While

credit and finance issues challenge some, others are struggling to cope with stringent regulatory environment.

SME sector of India is considered as the backbone of economy employing 60 million people, create 1.3 million

jobs every year and produce more than 8000 quality products for the Indian and international markets. With

approximately 30 million SMEs in India, 12 million people expected to join the workforce in next 3 years and

the sector growing at a rate of 8% per year, Government of India is taking different measures to increase their

competitiveness in the international market.

Factoring in another Emerging Market: India

We considered it essential to include another emerging market and the status of our desired business in it, as it

gives the reader an idea about the problems, environment, solutions, and essentially creates a benchmark to

understanding the basic characteristics of factoring in emerging markets. In spite of the various differences

between the Russian and Indian credit markets, we believed the overall goal, nature and structure of companies

entering such markets and the logistics of factoring would follow similar patterns. In the 1980ís, India was

witness to a virtual deregulation of its capital market, giving birth to a number of innovative financial

instruments and schemes were born. The policy of the power-that-be helped in the development of the money

market and capital market movers tried to transplant successful schemes of the west. However, despite all of their

efforts over the years, the small-scale sector was unable to recover its dues from the medium and large industries

particularly in the public sector, and thus the small-scale units faced a liquidity bind because of their inability to

collect dues. Available market data revealed that funds locked up in book debts were increasing at a faster rate

than growth in sales turnover or inventory build ups. Clearly, factoring was the only remedy available. While the

Worldwide factoring turnover was nearly $ 500 billion (1998), the factoring market in India is relatively non-

existent with only a few small p layers, although the market demand is estimated to be around a $ 1 billion

(according to a State Bank of India report). In India, factoring is considered as a source of short-term financing

and is viewed purely as a financing function ñ as a source of funds to fill the void of bank financing for

receivables for small-scale and other industries. This often leads to a catch 22 situation and in launching of

factoring services in India; the thrust should be on the twin areas of receivables management and credit

appraisals, especially since the small-scale sector lacks these sophisticated skills. Recent government efforts have

tried to maintain a thrust of the continuing momentum of economic reforms that have been announced in the

Union budget, as well as the Credit Policy (such as tax breaks for exporters and importers, terms of trade etc.).

During the year, the Reserve Bank of India (RBI) has tried to boost liquidity and reduce the cost of funds to

banks, by reducing bank rates, cutting CRR is and reducing the repo rate. It further announced the reduction of

interest rates on export financing and rationalizing the former. In light of this news, several agencies have

boosted export financing and also tightened their provisions, so as to better 21 support and help the core of

Indian exports, the small and medium scale business sector; such as the following:-The Export Import Bank of

India (Exim Bank), a pioneer in the forfaiting business in India and having detailed knowledge of the Indian

market, recently announced a tie up with West deutsche Landes Bank Girozentrale (West LB), Germany is 4th

largest banking group, to offer factoring and forfaiting services to Indian exporters. This would be a logical step

as structured trade financing is still in its infant stage in India. West LB is a major international player in the

business of factoring and forfaiting and other trade finance projects. In addition to the above, the International

Finance Corporation (IFC) has evinced interest in taking up a stake in the venture, aiming at around 25%, with

West LB having 40% and Exim Bank having 35%. A relatively small initial equity base is planned, along with

the commitment of other financially strong equity holders to provide lines of control at competitive prices when

required and give the new firm adequate financial advantage. With the setting up of this organization, it will no

longer be necessary for Indian exporters to approach foreign institutions for their financing needs. The setting up

of a new multi-product company offering export factoring and forfaiting under one umbrella will be particularly

beneficial to small and medium enterprise (SME) exporters, who are the backbone of the country’s exports.

Thus in lieu of the recent rise in international trade movements and in an effort to capitalize on the market,

several key players in the Indian market, such as the Exim Bank, the State Bank of India and other financial

agencies have stepped on the pedal to bolster their efforts and plans towards factoring and financing. Of course,

we have to keep in mind that the presence of an efficient and strong legal system is the single most important

factor in fostering the growth and success of factoring, and factoring as it is becoming clear, can only thrive in

conjunction with a favourable legal framework and judicial support ñ which India, along with Russia, still needs

to perfect!

Major Factoring Companies in India

Can Bank Factors Limited

SBI Factors and Commercial Services Pvt. Ltd.

The Hongkong and Shanghai Banking Corporation Ltd

India Factoring and Finance Solutions Pvt Ltd

Global Trade Finance Pvt. Limited

Foremost Factors Ltd.

Export Credit Guarantee Corporation of India Ltd.

Citibank NA, India Ltd.

Forfaiting

The forfaiting owes its origin to a French term ‘a forfait’ which means to forfeit (or surrender) ones’ rights on

something to someone else. Forfaiting is a mechanism of financing exports:

a. by discounting export receivables

b. evidenced by bills of exchanges or promissory notes

c. without recourse to the seller (viz; exporter)

d. carrying medium to long-term maturities

e. on a fixed rate basis up to 100% of the contract value.

In other words, it is trade finance extended by a forfaiter to an exporter seller for an export/sale

transaction involving deferred payment terms over a long period at a firm rate of discount. Forfaiting is generally

extended for export of capital goods, commodities and services where the importer insists on supplies on credit

terms. Recourse to forfaiting usually takes place where the credit is for long date maturities and there is no

prohibition for extending the facility where the credits are maturing in periods less than one year.

Forfaiting is a form of trade financing undertaken to facilitate export transactions. The process of

forfaiting thus has a lot of significance as it undertakes to solve the cash flow problems of the party taking the

benefit of factoring. In a forfaiting transaction, the exporter surrenders his right for claiming the payment for

services rendered or goods supplied to the importer in favour of the forfaiter. A deed is prepared stating the same

and the exporter receives cash payment from the facilitator. All the transactions of forfaiting are performed with

the support of a bank, which assumes the default risk possessed by the importer. The exporter before extending

finance for a forfaiting transaction looks into several critical aspects of the underlying goods or commodity. For

example, the bank would pay special attention towards the durability/perish ability nature of the goods,

authentication of the product (date of manufacturing, product code, etc.), packaging arrangements and other

precautions adopted during the stage of shipment etc. After these checks and verifications, the banker provides

the exporter with the funds. In other words, the forfaiting transaction helps an exporter with instant cash and

eliminates his cash flow problems. Forfaiting is a relatively new concept. It is a specialized form of factoring,

which is undertaken on export transactions on a non-recourse basis. This, however, does not mean that factoring

and forfaiting are one and the same type of trade financing.

Parties to Forfaiting

There are five parties in a transaction of forfaiting. These are

i. Exporter

ii. Importer

iii. Exporter’s bank

iv. Importer’s bank

v. The forfaiter.

The forfaiter assumes the following risks that arise in making the guarantee:

Economic risk of the insolvency of the debtor or his guarantor.

Country risk, which consists of the political risk, which particularly includes the conversion and transfer risk.

Exchange Risk- The risk of exchange rate fluctuations.

Collection Risk (loss of the receivables in the post, enforceability of the receivable).

Interest Risk- The risk of interest rate fluctuations during the credit period of the transaction.

Transfer Risk- The risk of an inability to convert local currency into the currency in which debt is

denominated.

Characteristics

The main characteristics of forfaiting are:

100% financing without recourse to the seller of the obligation,

The importer’s obligation is normally supported by a local bank guarantee (or ‘aval’).

The debt is usually evidenced by Bills of Exchange, Promissory Notes or a Letter of Credit.

Contracts in any of the world’s major currencies can be financed.

Finance can be arranged on a fixed (normal) or floating rate basis.

Documentation is very simple, requiring evidence of underlying transaction (copies of shipping documents)

and certain confirmations from obligor/guaranteeing bank.

Transactions can be concluded on a fixed or floating interest rate basis.

Exporter receives funds upon presentation of necessary documents, shortly after shipment.

Operating Procedures associated with Forfaiting The major parties around whom, a transaction of Forfaiting revolves are: An exporter, an importer, a domestic

bank, a foreign bank and a primary forfaiter. A primary forfaiter is a financial entity or an individual who does a

contract of forfaiting with the exporter and sells the payments of the importer. There is also a secondary forfaiter

too, who is a person or an intermediary who purchases the securities from the primary forfaiter and sells them in

the secondary market. The act of the secondary forfaiter helps in the growth of the secondary market activities of

the documents involved in a typical forfaiting transaction. The process of forfaiting gets underway the moment

an exporter asks for quotations from the overseas buyer on the issues of price, delivery, interest structure,

currency involved etc. Once the exporter is satisfied with the data received/quotation he approaches the EXIM

Bank, furnishes the name of the overseas party, name of the country, description of the goods, order details, base

price, payback period and the details of the export agency who will facilitate the transaction for the exporter. To

make a complete transaction of forfaiting, the forfaiter asks for the details of the banker of the overseas importer.

The overseas banker accepts and validates the documents of the transaction. This is known as the banker’s co-

acceptance. The Co-acceptance serves as a yardstick for the forfaiter as to the credit quality and the marketability

of the instruments accepted. EXIM Bank then collects from the overseas forfaiting agencies the representative

quotes on rates of discount, documentation charges and the commitment charges and informs the same to the

exporter. If the terms are acceptable for the exporter, he requests the EXIM Bank to obtain a firm quote from the

forfaiter. The exporter initiates a contract with the help of EXIM Bank with the overseas forfaiting agency. On

execution of the deal, EXIM Bank issues a formal certificate to the party in India. Subsequently, the exporter

ships the goods as per the specification.

Procedure of a Typical Transaction The normal courses of events leading to a forfaiting transaction are as follows:

(a) During the course of negotiations between an exporter and an importer for the supply of goods, the importer

asks for credit terms.

(b) The exporter approaches a forfaiter and asks for an indication of whether the forfaiter is willing to provide

this credit and how much it is likely to cost. At this stage the forfaiter will need to know:

The country of the importer

The importer’s name

The type of goods

The value of the goods

The expected shipment date

The repayment terms sought by the importer

Whether the importer’s obligations will be guaranteed by a bank, and if so, who?

(c) The forfaiter provides the exporter with an indication of the costs involved. At this stage neither party is

committed in any way.

(d) When the details of the commercial contract have been agreed, but usually before it has been signed, the

exporter asks the forfaiter for a commitment to purchase the debt obligations (bills of exchange, promissory

notes, etc.) created under the export transaction.

(e) The information required for this is the same as for an indication.

(f) The forfaiter issues a commitment which is accepted by the exporter and which is binding on both parties.

This commitment will contain the following points:

The details of the underlying commercial transaction.

The nature of the debt instruments to be purchased by the forfaiter.

The discount (interest) rate to be applied, together with any other charges.

The documents that the forfaiter will require in order to be satisfied that the debt being purchased is valid

and enforceable.

The latest date that the exporter can deliver these documents to the forfaiter.

(g) The exporter signs the commercial contract with the importer and delivers the goods.

(h) In return, if required, the importer obtains a guarantee from his bank, provides the documents that the

exporter requires in order to complete the forfaiting. This exchange of documents is usually handled by a

bank, often using a Letter of Credit, in order to minimise the risk to the exporter.

(i) The exporter delivers the documents to the forfaiter who checks them and pays for them as agreed in the

commitment.

(j) Since this payment is without recourse, the exporter has no further interest in the transaction. It is the

forfaiter who runs all the risks of non-payment.

Documentation 1. Copy of supply contract, or of its payment terms.

2. Copy of signed commercial invoice

3. Copy of shipping documents including certificates of receipts, railway bill, airway bill, bill of lading or

equivalent documents.

4. Letter of assignment and notification to the guarantor

5. Letter of guarantee, or aval. Bills of exchange may be ‘availed by’ the importer’s bank. ‘Aval’ is an

endorsement made on bills of exchange or promissory note by the guaranteeing bank by writing ‘per aval’ on

these documents under proper authentication.

Costs of forfaiting The forfaiting transaction has typically three cost elements:

1. Commitment fee, payable by the exporter to the forfaiter ‘for latter’s’ commitment to execute a specific

forfaiting transaction at a firm discount rate within a specified time.

2. Discount fee, interest payable by the exporter for the entire period of credit involved and deducted by the

forfaiter from the amount paid to the exporter against the availised promissory notes or bills of exchange.

3. Documentation fee.

Factoring Vis-à-Vis Forfaiting

Since the last few decades, factoring and forfaiting have gained immense importance, as one of the

major sources of export financing. For a layman, these two terms are one and the same thing. Nevertheless, these

two terms are different, in their nature, concept and scope. The first and foremost distinguishing point amidst

these two terms is that factoring can be with or without recourse, but forfaiting is always without recourse. Have

a glance at this article, to know about some more differences between factoring and forfaiting.

Comparison Chart

Basis for

Comparison

Factoring Forfaiting

Meaning Factoring is an arrangement that converts

the receivables into ready cash and the seller

doesn't need to wait for the payment of

receivables at a future date.

Forfaiting implies a transaction in which the

forfaiter purchases claims from the exporter

in return for cash payment.

Contract Between seller and factor. Between exporter and forfaiter.

Suitability For transactions with short-term maturity

period.

For transactions with medium to long term

maturity period.

Goods Trade receivables on ordinary goods. Trade receivables on capital goods.

Extent of

Finance

Normally 70-90% of the invoice value is

provided as advance.

The entire value of the bill is discounted, i.e.,

100% finance is provided to the exporter.

Basis of

Financing

Financing depends on the credit standing of

the exporter.

Financing depends on the financial standing

of the availing bank.

Type Can be either with recourse or without

recourse.

Can be without recourse only.

Cost Cost of factoring borne by the seller (client). Cost of forfaiting borne by the overseas buyer

(importer).

Negotiable

Instrument

Does not deal in negotiable instrument. Involves dealing in negotiable instrument.

Letter of Credit For ongoing open account sales, no Letter

of Credit is required.

Letter of Credit or bank guarantee is required

even for a single transaction.

Size of

transaction

No minimum size of transaction is

specified.

There is a minimum specified value per

transaction.

Services Besides financing, several other things like

sales ledger administration, debt recovery,

etc. are provided by the factor.

It is a pure financing arrangement only.

Advantages of Forfaiting

(i) Avoid Export Credit Risks

The exporter is completely free from may export credit risks that may arise due to the possibility of interest

rate fluctuations or exchange rates fluctuations or any political upheaval that may affect the collection of

bills. Forfaiting acts as an insurance against all these risks.

(ii) Simple and Flexible

All the benefits those are available to a client under factoring are automatically available under forfaiting

also. However, the greatest advantage is its simplicity and flexibility. It can be adopted to any export

transaction and the exact structure of fiancé can also be determined according to the needs of the exporter,

importer and the forfaiter.

(iii) Speedy Transaction

Fast, tailor-made financing solutions.

Commitments can be issued within hours/days depending on country.

(iv) Transaction simplicity

Because the financing is guaranteed against Promissory Notes or Bills of Exchange, the documentation is

concise and straightforward, permitting rapid completion of the deal.

Relieves the exporter from administration and collection problems.

No restrictions on origin of export.

(v) Cent per cent Finance

The exporter is able to convert his deferred transaction into cash transaction through a forfaiter. He is able to

get 100 per cent finance against export receivables.

(vi) Avoids Export Credit Insurance

In the absence of forfaiting, the export has to go for export credit insurance. It is very costly and at the same

time it involves very cumbersome procedures. Hence, if an exporter goes for forfaiting, he need not purchase

any export credit insurance.

(vii) Increase in Cash Flow

Forfaiting converts a credit-based transaction into a cash transaction. Therefore, Balance Sheet is not

burdened by accounts receivables, bank loans or contingent liabilities.

(viii) Enhancement of Competitive Advantage

Ability to provide supplier credit-based transaction into a cash transaction.

Ability to do business in countries where the credit risk would otherwise be too high.