Forfaiting

What Is Forfaiting?

Forfaiting is a method of trade finance where an exporter sells its medium to long-term receivables to a financial institution, known as a forfaiter, on a "without recourse" basis. This means the forfaiter assumes all the risks associated with the non-payment of the receivables by the importer, freeing the exporter from commercial and political risks¹⁷. Essentially, forfaiting converts a credit-based international sale into an immediate cash transaction for the exporter, significantly improving their cash flow¹⁶.

History and Origin

The concept of forfaiting emerged in Switzerland in the 1950s, primarily to facilitate the financing of capital goods exports¹⁵. Exporters of large, expensive equipment often faced a dilemma: they wanted immediate payment upon shipment, while importers sought deferred payment terms to allow the goods to generate revenue before payment was due¹⁴. Forfaiting bridged this gap by providing a mechanism for exporters to receive prompt payment without bearing the inherent risks of long-term international credit sales. The term "forfaiting" itself is derived from the French phrase "à forfait," meaning "without recourse," which encapsulates the core principle of transferring payment risk,¹³.¹²

Key Takeaways

• Forfaiting provides immediate liquidity to exporters by allowing them to sell future payment obligations at a discount.
• It is a "without recourse" transaction, meaning the forfaiter assumes all credit risk and other payment-related risks from the exporter.
• Forfaiting typically involves medium to long-term receivables, often supported by financial instruments like promissory notes or bill of exchanges.
• This method is particularly beneficial for transactions in high-risk markets or for goods requiring extended payment terms.
• It simplifies an exporter's balance sheet by removing foreign receivables and associated risks.

Formula and Calculation

The core of a forfaiting transaction involves the discounting of future receivables. The formula to calculate the discounted value (or net cash received by the exporter) in a simple forfaiting transaction is:

$\text{Net Cash Received} = \text{Face Value of Receivable} \times \left(1 - \frac{\text{Discount Rate} \times \text{Days to Maturity}}{360 \text{ or } 365}\right) - \text{Forfaiting Fees}$

Where:

• Face Value of Receivable: The total amount due from the importer.
• Discount Rate: The interest rate applied by the forfaiter, typically quoted as a margin over a benchmark rate (e.g., LIBOR), reflecting the risk profile of the importer and their country.
• Days to Maturity: The remaining period until the receivable is due, often including "days of grace" to account for payment transfer times.
• Forfaiting Fees: Additional charges levied by the forfaiter for their services, which may include commitment fees or other administrative costs.

Interpreting Forfaiting

Forfaiting is interpreted as a comprehensive risk mitigation and liquidity solution for exporters engaged in international trade. When an exporter engages in forfaiting, they are effectively transferring the entire burden of collecting future payments and the associated risks—such as political risk, interest rate risk, and exchange rate risk—to the forfaiter. This allows the exporter to focus on their core business activities without concerns about cross-border payment complexities or potential defaults. The cost of forfaiting, reflected in the discount rate and fees, represents the price the exporter pays for this risk transfer and immediate cash.

Hypothetical Example

Imagine "Global Machinery Inc." (an exporter) in the United States sells heavy construction equipment worth $5 million to "African Infrastructure Ltd." (an importer) in a developing nation. African Infrastructure Ltd. requires payment terms of three years, payable in semi-annual installments, and supported by promissory notes guaranteed by their local bank.

Global Machinery Inc. wants to avoid the credit risk and the long wait for payment. They approach "TradeSure Forfaiting," a specialized financial institution. TradeSure Forfaiting evaluates the transaction, the importer's bank guarantee, and the country risk. They agree to purchase the promissory notes at a discount rate of 8% per annum, plus an upfront fee of 0.5% of the face value.

Upon shipment of the equipment and receipt of the guaranteed promissory notes, Global Machinery Inc. sells these notes to TradeSure Forfaiting. TradeSure Forfaiting immediately pays Global Machinery Inc. the discounted value of the $5 million, minus their fees. Global Machinery Inc. receives immediate cash flow and is no longer concerned with collecting payments from African Infrastructure Ltd. or any potential payment defaults. TradeSure Forfaiting now holds the promissory notes and will collect payments from African Infrastructure Ltd.'s bank as they fall due over the next three years.

Practical Applications

Forfaiting is a vital tool primarily used in international trade for transactions involving medium to long-term credit, typically ranging from 180 days to seven years,. It¹¹s applications include:

• Export of Capital Goods: Commonly used for large-value sales of machinery, equipment, or industrial plants where importers require extended payment periods.
• ¹⁰ Accessing New Markets: Enables exporters to conduct business with buyers in countries perceived as having higher commercial or political risks, as the forfaiter assumes these risks.
• Improving Cash Flow: Provides immediate liquidity to exporters, converting deferred receivables into instant cash, which can be reinvested into operations or growth.
• ⁹ Off-Balance Sheet Financing: Forfaiting can allow exporters to remove receivables from their balance sheet, improving financial ratios and freeing up credit lines.
• ⁸ Structured Finance: It can be integrated into larger structured finance deals, particularly for infrastructure projects or public-private partnerships where guaranteed long-term payment streams are involved.
• ⁷ The U.S. International Trade Administration highlights forfaiting as a method for exporters to obtain cash by selling foreign accounts receivable at a discount, improving cash flow, especially for sales to foreign buyers who need longer financing terms.

##⁶ Limitations and Criticisms

While forfaiting offers significant advantages, it also has limitations and potential drawbacks.

• Cost: The primary limitation of forfaiting is its cost. Because the forfaiter assumes all risks on a "without recourse" basis, the discount rate and fees can be higher compared to other financing methods. This cost is typically passed on to the importer in the form of higher prices for goods or services.
• ⁵ Transaction Size: Forfaiting is generally suitable for larger transactions. The minimum bill size is often substantial, typically starting from $100,000 to $250,000, with some forfaiters preferring transactions over $500,000,. Thi⁴s makes it less practical for small-value trade deals.
• Negotiability of Instruments: The underlying debt instruments, such as bills of exchange or promissory notes, must be unconditional and freely transferable to enable the forfaiter to take on the obligation and potentially trade it on a secondary market. If the documentation is not precisely in order, the transaction may face hurdles.
• Market Liquidity: While a secondary market for forfeited instruments exists, its liquidity can vary, potentially affecting the forfaiter's ability to offload the risk or adjust their portfolio.
• ³ Limited Customization: While flexible, some complex trade scenarios might not fit neatly into standard forfaiting structures.
• The Malta Financial Services Authority (MFSA) notes that, being a "without recourse" business, forfaiting poses various risks to the financial institution undertaking the activity, including sovereign/political risk and credit risk, which the forfaiter must manage.

##² Forfaiting vs. Factoring

Forfaiting and factoring are both methods of receivables finance where a business sells its accounts receivable to a third party to obtain immediate cash. However, they differ significantly in their application and characteristics:

The key distinction lies in the recourse nature: forfaiting almost universally involves the forfaiter taking on the default risk without recourse to the original exporter. Factoring, while offering non-recourse options, frequently retains recourse to the seller, meaning the seller remains liable if the debtor fails to pay. Additionally, forfaiting focuses on discrete, larger international trade transactions for capital goods, while factoring often involves an ongoing agreement for a company's entire sales receivables.

FAQs

What types of financial instruments are typically involved in a forfaiting transaction?

Forfaiting transactions commonly involve negotiable instruments that evidence the debt, such as promissory notes, bill of exchanges, or deferred payment letter of credits. These instruments are legally enforceable and transferable.

Does forfaiting protect against all risks for the exporter?

Forfaiting provides comprehensive protection against non-payment risks, including commercial credit risk, political risk, and transfer risk (difficulty in converting local currency to a convertible one). It also typically shields the exporter from interest rate risk and exchange rate risk related to the receivables. However, the exporter remains liable for the quality and delivery of the goods or services provided.

Can small businesses use forfaiting?

While traditionally associated with large transactions, forfaiting can be used by small to medium-sized enterprises (SMEs) for significant export deals, particularly those involving capital goods. How¹ever, the fees associated with forfaiting might be proportionally higher for smaller transactions, and the minimum transaction value can be a barrier for very small deals.