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| Forfaiting Is About Eliminating Risks | |
Saturday, August 05, 2006
Index Of Articles
Index Of Articles
Forfaiting Is About Eliminating Risks
Characteristics of Forfaiting100% financing without recourse to the seller of the obligation.
- Importer's obligation is normally supported by a local bank guarantee or aval.
- The debt is typically evidenced by Letter of credit, Bills of Exchange, Promissory Notes. Credit periods can range from 90 days to 10 years
- Amounts financed to be upwards of USD 2,50,000/-
- Contract in any of the world's major convertible currencies can be financed.
- Finance to be either on a fixed (market norm) or floating rate basis
Risk Elimination
Elimination of the following Risks associated with cross border transactions.
- Commercial Risk - The risk of non-payment by a non-sovereign or private sector buyer or borrower in his home currency arising from insolvency.
- Political Risk - The risk of the borrower country government actions, which prevent or delay the repayment of export credits.
- Transfer Risk - The risk of an inability to convert local currency into the currency in which debt is denominated.
- Interest Risk - The risk of interest rate fluctuations during the credit period of the transaction.
- Exchange Risk - The risk of exchange rate fluctuations.
- High Value Exports
- Heavy Machinery / Capital Goods
- Consumer Durable
- Vehicles
- Bulk Commodities
- Consultancy and Construction Contracts
- Low Value but repetitive business
- Drugs & Pharmaceuticals
- Dyes and Chemicals
- Textiles / Leather
- Granites
Forfaiting In India
Origins of ForfaitingForfaiting evolved in the 1960s and was originally used to finance exports from countries in Western Europe to East European countries. With the growth in global trade, the product is now widely used to finance trade with all geographic areas, and has also been extended from its traditional role of post-shipment finance to provide pre-export finance, structured trade finance, project finance and even working capital.
In order to remain competitive, exporters are often faced with having to allow their importing partners longer period of payment. Such difficulties expose the exporter to a number of risks which can assume substantial proportions, depending on the country of the importer and the period allowed for payment. On top of typical commercial risks, such as insolvency of the importer, unwillingness or inability to pay, exporters have to consider the difficulties in appraising the monetary, economic and political risks inherent in the importer's country. The requirements placed on the financial institutions by exporters seeking solutions to the ever-growing complexities of international financing have led to an increased demand for Forfaiting.
The term "a forfait" in French means, "relinquish a right". Here, it refers to the exporter relinquishing his right to a receivable due at a future date in exchange for immediate cash payment, at an agreed discount, passing all risks and responsibilities for collecting the debt to the forfaiter.
What is Forfaitng ?
Forfaiting is the discounting of international trade receivable on a 100% "without recourse" basis. It is a form of suppliers credit involving the sale or purchase of receivables falling due at some future date. The exporter is, of course, responsible for the validity of his order and execution thereof, but once documentation has been delivered and accepted and discounting is done, there is absolutely no recourse to the Exporter, with the exception of an underlying fraudulent transaction. Forfaiting effectively transforms a credit sale into a cash sale.
Forfaiting transforms the supplier's credit granted to the importer into cash transaction for the exporter protecting him completely from all the risks associated with selling overseas on credit.
Traditionally forfaiting is fixed interest rate and medium term (3-5 years) financing. It can however, be structured on a floating rate interest basis as well as for longer periods up to 10 years or for shorter periods down to 90 days. Forfaiting is generally suitable for high value exports like heavy machinery, capital goods, consumer durable, vehicles, bulk commodities, consultancy and construction contracts and project exports.
Forfaiting in India - Regulatory Aspects
Forfaiting as an export financing option in India has been approved by the Reserve Bank of India vide its circular A.D. (G.P. Series) No. 3 dated February 13, 1992. The Forfaiting facility is to be provided by an international forfaiting agency through an Authorised Dealer (see RBI Circular No. 42 A. D. (M.A.) series dated October 27, 1997).
Forfaiting proceeds, on a without recourse basis, are to be received in India as soon as possible after shipment but definitely within the 180 day period specified by RBI for all exports. A Forfaiting transaction is to be routed through an Authorised Dealer, who apart from handling documentation will also provide Customs Certification for GR Form purposes.
Cash Flow Crunch? Try Factoring!
Is your cash flow like a yo-yo – one minute it’s up the next it is down?Take an ordinary small to medium sized business with growing turnover – orders are up and the business has the opportunity to increase profitability. But still one thing holds it back – its CASH FLOW.
Look at a typical monthly cycle of this business:
In the first week of the month several of its major customers settle their account. The business is able to pay some of its suppliers and the overdraft is within the limit set by their bankers. The yo-yo is up.
In the second week they receive a large order which will require the purchase of additional raw materials from a supplier who will need to be paid up front to keep the account within its credit limit. Unfortunately the bank overdraft limit has been reached and therefore the materials required cannot be purchased and therefore the order has to be turned down. The yo-yo is down.
In the third week a concerted effort is made to collect money in on overdue accounts in order to provide sufficient funds to pay monthly wages at the end of the month. The yo-yo is up.
The final week of the months sees the wages paid taking the overdraft back towards its limit with quarterly VAT due at the end of the month. This payment will have to be delayed to the first week of the following month when payments from customers settling end-of-month accounts are received. The yo-yo is down.
And so it goes on until eventually the yo-yo does not come back up.
So what is the solution? Three possible answers come to mind.
1) Put more of your own money into the business if you have any. A second mortgage on your home perhaps.
2) Ask an outside investor to put in the money – but this could mean parting with some of the equity of the business – future profits would have to be shared.
3) Borrow more money from the bank – but the bank will want more security before they will increase funding – have you got any to give?
But there is a fourth solution - Factoring.
Factoring releases cash tied-up in the sales ledger. Therefore as the business expands so does the funding available thus beating the cash flow yo-yo affect.
What is main source of day-to-day cash into the business (in a lot of instances the only source)? The answer is the sales ledger. Where an enterprise sells business to business this is normally done on credit terms.
Therefore you’ve made the sale, created a profit but you don’t yet have the cash. And it is this that creates the yo-yo affect on the cash flow needs of the business. With factoring the cash is available as you need it rather than when your customers choose to pay you thus allowing you to control your cash flow needs.
Factoring vs Invoice Discounting
Explains how Invoice Discounting differs from FactoringInvoice Discounting can be described as the provision of finance against the security of receivables and in this respect is similar to factoring. The major differences is that the facility is confidential i.e. the customer is unaware of the facility and the supplier is responsible for the sales ledger administration.
Invoice discounting can only be provided where goods or services are supplied business to business on credit terms. Bad debt protection may be included in the facility if required.
The criteria for obtaining an invoice discounting facility is higher than for factoring and the service provider will be influenced by the following:
a) The quality and quantity of customers with particular attention to the spread. Ideally no one customer’s balance outstanding should be more than 20% of the total debts outstanding.
b) The supplier should be able to demonstrate good credit control procedures with debts being collected in a timely manner.
c) A good sales ledger system should be in place preferably computerised and kept up-to-date.
d) The business should be able to demonstrate that it is trading profitably and has a tangible net worth. Audited accounts may be required as evidence of the financial strength of the business.
The major features of an invoice discounting facility are outlined below:
a) The supplier is responsible for the continued maintenance of the sales ledger and the collection of sums due for payment.
b) The supplier’s customers are unaware of the invoice discounting facility.
c) The service provider will open a trust account at a nominated bank in the name of the supplier. All remittances collected by the supplier must be paid into this account.
d) The supplier will send regular notifications of invoices to the service provider together with supporting documentation as agreed with the service provider.
e) Credit Notes should be advised in the same manner.
f) The service provider will make available to the supplier an initial payment against invoices at an agreed percentage which can be up to 85% of the value of the invoices including VAT.
g) The remaining percentage will be paid to the supplier when the customer has made its payment which should be cleared through the nominated trust account.
h) The service provider will send the supplier monthly statements which will include a sales ledger control account.
i) The supplier will be required to provide a detailed sales ledger analysis at each month-end which must include a reconciliation to the service provider’s sales ledger control account. An age analysis will be required by the service provider.
j) The service provider will normally unapprove any debts older than 90 or 120 days from invoice dependent on the terms of the invoice discounting agreement between the supplier and the service provider.
k) The service provider will require to undertake regular audits of the suppliers accounting records primarily the sales ledger normally on a quarterly basis.
Please note definition of terminology used in this article as follows:
The Supplier – refers to the business providing goods or services business to business on credit terms.
The Customer – refers to recipient of the goods or services provided by the Supplier.
The Service Provider – refers to the financial organisation offering an Invoice Discounting facility to the Supplier.
Factoring - A Solution For Small or Start-up Businesses
Factoring - the benefits for a small or startup business When starting a new business it is important that sufficient capital is provided initially to enable the enterprise to successfully establish itself. This capital could be in the form of money provided by the prime movers be it a sole trader, partnership or share capital in respect of a limited company. Additionally a bank loan or overdraft may supplement this capital and leasing may be used to purchase certain fixed assets. A mortgage can be taken out for the purchase of any property requirements. Further capital can be found by approaching a venture capitalist or business angel or perhaps friends and family. However this tends to dilute the prime movers interest in the business resulting in a smaller share of future profits.
All the above will contribute finance for the establishing of a business in order that it can initiate its trading activity. Hopefully if it has got its sums right it will have sufficient working capital to successfully go forward. In working capital we mean adequate cash flow to pay wages to staff and make purchases from suppliers enabling the production and selling of goods or services. If it sells direct to the public i.e. as in a shop, the cash flow will come in the form of cash paid immediately by its customers for those goods or services.
However if it is trading business to business it has another problem cash flow wise. It is normal practice in the UK to offer credit terms to your customers ranging from 7 days say for employment agencies to 90 days in the printing industry. The result is that when a sale is made the cash is not immediately available for the payment of wages and suppliers. Therefore the business will need to have raised an additional amount of capital in its initial stage to fund this or seek further funding so that it can continue to trade. Also it is normal for a young business to be seeking rapid growth in its initial stages of development to establish itself in its marketplace but when offering credit terms to its customers it will need more and more working capital to finance these sales. This is almost certainly to be further exacerbated by customers not paying on time – the terms say are 30 days but the customer takes 60 to pay. For a small business this can be a huge headache as prompt settlement of debt is vital to the development of the business and often the prime movers find themselves more and more drawn into chasing up outstanding invoices when their time should be better spent running other areas of the business.
The enterprise has a stark choice now – does it stand still in order to work at the level its working capital can support or look for further funding so as to grow the business. It is often vital for small businesses to continue to grow to achieve their profitability targets. Stay at the same level and risk making a loss or grow the business and risk a cash flow shortage by over trading. Further loans could be sought from a bank but these are normally finite and therefore as growth continues further funding is needed. Banks often require security i.e. personal guarantees to increase an overdraft or approve further loans and also seek evidence of trading results such as management accounts. Also there is still the problem as credit sales continue to grow of getting the customers to pay on time – in fact as turnover grows so does this problem. More and more time needs to be spent on chasing up overdue accounts and if you don’t chase there’s a good chance you won’t get paid. Is there a better solution?
The answer is YES there is – FACTORING
Factoring could well be the answer as unlike other sources of finance it is expressed as a percentage normally providing up to 85% of the value of each invoice initially with the rest paid when the customer pays. This means it is flexible in the sense that as the business grows so the funding from factoring grows providing adequate working capital to pay wages and suppliers in a timely manner allowing the business to continue to grow without the fear of over trading.
What about the burden of the ever increasing and time consuming need to chase customers for overdue payments. Is there a better solution?
The answer is YES there is – FACTORING
Factoring not only provides finance against the sales ledger but also has a service element attached to it where the factor will take over the administration of the sales ledger on behalf of your business so relieving the prime movers from the onerous task of chasing up customers for payment and therefore allowing them to do what they do best – running their business. For a business to be successful you do not want your prime mover bogged down in administration – you use accountants to collate financial records, solicitors to look after legal matters, etc. so why not use a factoring company to outsource your credit control. They will maintain the sales ledger on your behalf sending out regular customer statements setting out when invoices are due for payment and following-up on any invoice not paid on time. By offering a professional collection and credit control service cash can be collected in a more timely manner thus improving your cash flow and reducing pressure on your working capital demands.
They can also advise on the credit worthiness of both your existing and new customers. In order to minimise bad debts potential customers should always be checked out for credit worthiness however this is still no guarantee that they won’t go bust and leave you with a bad debt. This leads to another potential problem to a small business looking for rapid growth – as it offers more credit to more customers so increases its bad debt risk. One bad debt can turn a profitable business into a loss making business and create a major cash flow headache. Is there a better solution?
The answer is YES there is – FACTORING
Factoring also offers bad debt protection if it is required. Providing the business operates within the limits set by the factoring company they can receive 100% protection against bad debts. This is a major comfort to any small business looking for expansion and it is surprising that most enterprises do not take up this part of service offered by factoring companies.
To sum up there are major benefits to a small business in factoring when looking for finance to grow the business both in the finance it provides and the support it offers providing a sales ledger administration service and bad debt protection.
Is Factoring Meant For Me?
Your Business Is your business growing? Do you need additional working capital to finance that growth? Then factoring could be the answer providing funds of up to 85% against the value of your trade debtors. Factoring is only available against trade debts.
Your Product
Not everybody’s product/services are suitable to factoring; the most suitable being the simplest or more straightforward type of product/service which can easily be shown to have been provided for example by a signed delivery note or timesheet. However factoring companies vary in the types of businesses they will factor.
Your Debtors
These should be trade debtors where goods/services have been provided under credit terms normally not exceeding 90 days. A factor will look at the quality and spread of the debtors before making an offer of a factoring facility. Equally important is your bad debt record, the ageing of the sales ledger and the overall collection performance.
Your Paper Trail
Factoring companies will be interested in your paper trail from the taking of an order to the delivery/provision of goods/services stipulated in that order. It is important that your record keeping is well maintained and that they can be easily followed through to the issue of an invoice and updating of the sales ledger.
Your Cashflow Requirements
Essentially you are looking at factoring specifically to improve your cash flow. Factoring can do this in two ways:
a) By providing cash in advance of your customer paying by offering an initial payment of up to 85% against invoices as they are issued by you.
b) By outsourcing the management of the sales ledger to the factor and thereby allowing them to improve your collection performance and reduce your debt turn.
Your Credit Control Requirements
In a fast expanding busy company there is not always time to implement and control good credit control procedures. So by outsourcing this to a the factoring company could make good business sense as the factor can provide you with a disciplined and regulated credit control procedure to the benefit of you and your business. Consideration should be given to how much you as the prime mover are spending in the chasing of slow-paying customers when your time could be better utilised growing your business.
Your Bad Debt Risk
Another facility offered by factoring companies is bad debt protection whereby they will give credit limits to your customers and should that customers business fail the factor will take the bad debt up to the limit set. This is referred to as non-recourse factoring.
To Sum Up
What are the main benefits to your business of factoring?
1) The provision of finance for growth.
2) The ability by you to take funding from the factor of the agreed initial payment percentage as and when you require the money.
3) Improved cash flow by releasing working capital to your business.
4) An opportunity to outsource the administration of your sales ledger including the chasing up of overdue accounts.
5) Improved credit control.
6) Bad Debt protection.
7) Improved working capital allows you to agree better terms with your suppliers.
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