Chapter-16 FACTORING AND FORFAITING
Structure We will discuss now factoring and forfaiting and how it works, its major terms and conditions and how these functions in India. There are various advantages and disadvantages in factoring and forfaiting which we are going to discuss in this chapter. For our discussion we will take in to consideration following points..
Introduction A. FACTORING 16.2 What is factoring? 16.3 Factoring in India 16.4 Characteristics of factoring 16.5 Different types of Factoring 16.6 Factoring companies in India 16.7 NBFC-Factoring B. FORFAITING 16.8 What is Forfaiting 16.9 Major Terms and conditions of forfeiting 16.10 Forfaiting The Modus Operandi 16.11 Forfaiting Costs 16.12 Advantages and disadvantages of forfaiting 16.13 Forfaiting in India 16.14 Difference Between Factoring and Forfaiting
Introduction: Proper financing is a crucial part of any business, more so in exports where the cost of finance is affected by domestic as well as international factors. Availability of a variety of suitable financing options can encourage small and medium export businesses where raising of money to finance exports is often more an issue than actual receipt of orders. Conventional financing methods like bank loans, equity financing etc. come with a lot of conditions and strings attached which new or small exporters find difficult to meet. For instance new firms may find it difficult to raise bank loans (since there is no proof that business will be viable, no balance sheets to show healthy profits). Equity participation implies a more long-term commitment and accountability towards the shareholders.
The two financing methods of factoring and forfaiting could provide viable options. Both provide immediate cash to the exporter that virtually wipes out (for the exporter) the credit period extended to the importer. This credit period extends from the time of shipment of goods to the time of receipt of payment from the buyer abroad. The credit period can extend from a couple of months to several years (in the case of deferred payment contracts, project exports etc.) and hits the liquidity of many export businesses. Forfaiting and factoring are similar in that a third (factoring or forfaiting) agency takes over the accounts/trade receivables of the exporter at a certain discount. The exporter in turn receives immediate reimbursement of the receivables less the discount due to the factoring or forfaiting agency. However the conditions and stipulations governing factoring and forfaiting are a little different.
FACTORING
What is factoring? The Factoring Act, 2011 defines the Factoring Business as the business of acquisition of receivables of assignor by accepting assignment of such receivables or financing, whether by way of making loans or advances or in any other manner against the security interest over any receivables. However, credit facilities provided by banks in the ordinary course of business against security of receivables and any activity undertaken as a commission agent or otherwise for sale of agricultural produce or goods of any kind whatsoever and related activities are expressly excluded from the definition of Factoring Business.
Factoring in India: Factoring is the conversion of credit sales into cash. In factoring, a financial institution (factor) buys the accounts receivable of a company (Client) and pays up to 80%(rarely up to 90%) of the amount immediately on agreement. Factoring company pays the remaining amount (Balance 20% minus finance cost minus operating cost) to the client when the customer pays the debt. Collection of debt from the customer is done either by the factor or the client depending upon the type of factoring. The account receivable in factoring can either be for a product or service. Examples are factoring against goods purchased, factoring in construction services (in government contracts it is assured that the government body can pay back the debt in the stipulated period of factoring and hence contractors can submit the invoices to get cash instantly), factoring against medical insurance etc. Let us see how factoring is done against an invoice of goods purchased.
Characteristics of factoring Usually the period for factoring is 90 to 150 days. Some factoring companies allow even more than 150 days. Factoring is considered to be a costly source of finance compared to other sources of short term borrowings. Factoring receivables is an ideal financial solution for new and emerging firms without strong financials. This is because credit worthiness is evaluated based on the financial strength of the customer (debtor). Hence these companies can leverage on the financial strength of their customers.
Bad debts will not be considered for factoring. Credit rating is not mandatory. But the factoring companies usually carry out credit risk analysis before entering the agreement. Factoring is a method of off balance sheet financing. Cost of factoring=finance cost + operating cost. Factoring cost vary according to the transaction size, financial strength of the customer etc. The cost of factoring varies from 1.5% to 3% per month depending upon the financial strength of the client's customer. For delayed payments beyond the approved credit period, penal charge of around 1-2% per month over and above the normal cost is charged (it varies like 1% for the first month and 2% afterwards).
Different types of Factoring Following are major types of factoring: Disclosed and Undisclosed Recourse and Non-recourse A single factoring company may not offer all these services. Disclosed Factoring In disclosed factoring client's customers are notified of the factoring agreement. Disclosed type can either be recourse or non-recourse. Undisclosed factoring In undisclosed factoring, client's customers are not notified of the factoring arrangement. Sales ledger administration and collection of debts are undertaken by the client himself. Client has to pay the amount to the factor irrespective of whether customer has paid or not. But in disclosed type factor may or may not be responsible for the collection of debts depending on whether it is recourse or non-recourse.
Recourse factoring In recourse factoring, client undertakes to collect the debts from the customer. If the customer don't pay the amount on maturity, factor will recover the amount from the client. This is the most common type of factoring. Recourse factoring is offered at a lower interest rate since the risk by the factor is low. Balance amount is paid to client when the customer pays the factor. Non-recourse factoring In non-recourse factoring, factor undertakes to collect the debts from the customer. Balance amount is paid to client at the end of the credit period or when the customer pays the factor whichever comes first. The advantage of non-recourse factoring is that continuous factoring will eliminate the need for credit and collection departments in the organization.
Factoring companies in India Can bank Factors Limited SBI Global The Hong Kong and Shanghai Banking Corporation Ltd IFCI Factors Limited Export Credit Guarantee Corporation of India Ltd: Citibank NA, India Small Industries Development Bank of India (SIDBI) Standard Chartered Bank YES BANK Limited India Factoring and Finance Solutions Pvt Ltd
NBFC-Factoring: What is an NBFC-Factor? NBFC- Factor means a non-banking financial company fulfilling the Principal business criteria i.e. whose financial assets in the factoring business constitute at least 75 percent of its total assets and income derived from factoring business is not less than 75 percent of its gross income, has Net Owned Funds of Rs. 5 crore and has been granted a certificate of registration by RBI under section 3 of the Factoring Regulation Act, 2011.
Entry point norms for NBFC-Factor Every company registered under Section 3 of the Companies Act 1956 seeking registration as NBFC-Factor shall have a minimum Net Owned Fund (NOF) of Rs. 5 crore. Existing companies seeking registration as NBFC- Factor but do not fulfil the NOF criterion of Rs. 5 crore may approach the Bank for time to comply with the requirement. What would happen with the existing companies registered with RBI as NBFCs and conducting factoring business that constitute less than 75 percent of total assets / income? Such a company shall have to submit to RBI, a letter of its intention either to become a Factor or to unwind the business totally, and a road map to this effect. The company would be granted CoR as NBFC-Factor only after it complies with the twin criteria of financial assets and income. If the company does not comply within the period as specified by the Bank, it would have to unwind the factoring business.
Is it compulsory for all entities to get registered with RBI to conduct factoring business? Yes. An entity not registered with the Bank may not conduct the business of factoring unless it is an entity mentioned in Section 5 of the Act i.e. a bank or any corporation established under an Act of Parliament or State Legislature, or a Government Company as defined under section 617 of the Companies Act, 1956. If a company does not fulfil the principal business criteria for factoring and has no intention of getting itself registered as a Factor with the Bank, can it continue to do factoring activities with its group entities. No. As per Section 3 of the Factoring Act 2011, no Factor can commence or carry on the factoring business without a) obtaining a CoR from the Reserve Bank, b) fulfilling the principal business criteria.
Can NBFC-Factors undertake Import and Export Factoring? Yes, however, such NBFC-Factors will need to obtain the necessary authorization from the Foreign Exchange Department of the Bank under FEMA 1999 as amended and adhere to all the FEMA regulations in this regard. Is it necessary for NBFC-Factors to register every factoring transaction with the Central Registry? Under Section 19 of the Factoring Act, 2011 every Factor is under obligation to file the particulars of every transaction of assignment of receivables in his favour with the Central Registry to be set-up under section 20 of the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002 (54 of 2002), within a period of thirty days from the date of such assignment or from the date of establishment of such registry, as the case may be.
Do NBFC-Factors have to comply with a separate set of prudential regulations? No, The provisions of Non-Banking Financial (Non-deposit Accepting or Holding) Companies Prudential Norms (Reserve Bank) Directions, 2007 or Non-Banking Financial (Deposit Accepting or Holding) Companies Prudential Norms (Reserve Bank) Directions, 2007, as the case may be and as applicable to a loan company shall apply to an NBFC-Factor. Are there a separate set of Returns that the NBFC-Factor has to submit? The submission of returns to the Reserve Bank will be as specified presently in the case of registered NBFCs.
FORFAITING
What is Forfaiting? Forfaiting in French means to give up one s right. Thus, in forfaiting the exporter hands over the entire export bill with the forfaiter and obtains payments. The exporter has given up his right on the importer which is now taken by the forfaiter. By doing so, the exporter is benefited as he gets immediate finance for his exports. The risk of his exports is now borne by the forfaiter. In case if the importer fails to pay, recourse cannot be made on the exporter. Forfaiting is the sale by an exporter of export trade receivables, usually bank guaranteed, without recourse to the exporter. Such receivables include Letters of Credit (with or without Bills of Exchange) Promissory Notes with Aval (guarantee), Bill of Exchange with Aval, Bank Guarantees Payable to an Exporter in one country from an Importer in another country.
Forfaiting as a financing concept has been in use across the world since the 1960s. The word forfait means to forgo one's right to something. In the context of export finance, the exporter forgoes his right to receive payment from the importer at later date and surrenders the right to collect payment to a third party or agency (known as forfeiter). Instead the exporter receives an immediate reimbursement of his payment less certain discounts from the forfeiter. Normally, these payments are due at a later date, forcing the exporter to bear the cost for the intervening period, as well as being exposed to the risks of exchange rate fluctuations, political situations etc.
These are risks which expose a small or medium exporter to significant erosion of profits. With forfaiting finance, the exporter passes on his debts as well as attendant risks to the forfaiting agency. This form of financing is referred to as without recourse financing (in case the debt cannot be recovered there is no risk for the exporter). Forfaiting is a medium-term financing option typically for the three to seven year time frame
Major Terms and conditions of forfeiting: there is a discounting of the amount to be received from the importer discounting is on a fixed rate debt is in the form of bills of exchange or promissory notes guaranteed by a bank such financing is without recourse to the seller 100% of the amount receivable can be financed in this manner
Forfaiting The Modus Operandi The parties/agencies involved in a forfaiting transaction include the exporter, the importer, a forfaiting agency, a bank that stands guarantee (aval) for the bills of exchange or promissory notes (this is normally the importers bank) and the Exim bank in India acts as the facilitating agency between the Indian exporter and the forfaiting agency. Typically, the exporter negotiates terms like price, payment currency, credit period and the like with their overseas buyer. The exporter then approaches the Exim Bank with these terms. The Exim Bank obtains a tentative forfaiting quotation from a forfaiting agency. Armed with this quote the exporter can now finalise the contract with the buyer.
The exporter should ensure that most of the forfaiting charges are passed on to the buyer. Once the terms have been settled with the buyer, a final forfeiting quote is obtained by the Exim Bank. If this quote is acceptable, the exporter signs the contract with the buyer as well as a separate one with the forfaiting agency. Once shipment of goods has taken place the exporter obtains availed (guaranteed) bills of exchange from the importer (through a bank) or availed promissory notes. These bills of exchange or promissory notes are endorsed by the exporter and are routed to the forfaiting agency through the Exim Bank.
The forfaiting agency will then remit the payment due to the exporter to an account of the exporter's bank in the country where the forfaiting agency is based. This bank then transfers the amount to the exporter in India, and the exporter will be provided with a Certificate of Foreign Inward Remittance as proof. When the promissory notes/bills of exchange reach maturity, the forfeiting agency collects the payment from the aval (the bank or agency that stands guarantee irrespective of whether the importer has paid the aval).
Forfaiting Costs: In a forfaiting transaction, the exporter should bear the following costs A commitment fee has to be paid to the forfeiter for the period of time from when the commitment is entered into upto the date of discounting or date of expiry of the contract. The commitment fee typically ranges between 0.5 to 1.5 per cent per annum of the utilised portion of the forfeit amount. This fee has to be paid irrespective of whether the export takes place or not. The second, is the actual discount fee which is the interest on the receivable amount for the entire period of credit as well as a premium for the various risks involved. This fee is based on prevailing market interest rates including LIBOR (London Inter Bank Offered Rate). These are the two main costs involved. In addition, there could be documentation costs in case of a lot of paperwork, penalties, handling charges, etc. The Exim Bank which acts as the facilitator also charges a service fee which can be paid in Indian rupees.
This fee is based on prevailing market interest rates including LIBOR (London Inter Bank Offered Rate). These are the two main costs involved. In addition, there could be documentation costs in case of a lot of paperwork, penalties, handling charges, etc. The Exim Bank which acts as the facilitator also charges a service fee which can be paid in Indian rupees. As per RBI regulations it is mandatory that the discount fees and any documentation fees charged by the forfeiter should be passed on to the overseas buyer. During shipping, it is not necessary that any of the forfaiting fees be shown separately, they can be included in the FOB value indicated in the invoice. The export contract can be executed in any of the major convertible currencies of the world, in order to be eligible for forfeiting
Advantages and disadvantages of forfaiting Advantages of forfaiting It provides immediate funds to the exporter who is saved from the risk of the defaulting importer. It is an earning to commercial banks who by taking the bills of highly valued currencies can gain on the appreciation of currencies. The forfaiter can also discount these bills in the foreign market to meet more demands of the exporters. There is very little risk for the forfaiter as both importer s bank and exporter s banks are involved. Letter of Credit plays a major role for the forfaiter. Moreover, he enters an agreement with the exporter on his terms and conditions and covers his risks by separate charges. As forfaiting provides 100% finance to exporter against his exports, he can concentrate on his other exports.
Disadvantages or Drawbacks of Forfaiting The following are some of the disadvantages of forfaiting. Forfaiting is not available for deferred payments especially while exporting capital goods for which payment will be made on a deferred basis by the importer. There is discrimination between Western countries and the countries in the Southern Hemisphere which are mostly underdeveloped (countries in South Asia, Africa and Latin America). There is no International Credit Agency which can guarantee for forfaiting companies which affects long-term forfaiting. Only selected currencies are taken for forfaiting as they alone enjoy international liquidity.
Forfaiting in India For a long time, Forfaiting was unknown to India. Export Credit Guarantee Corporation was guaranteeing commercial banks against their export finance. However, with the setting up of export-import banks, since 1994 forfaiting is available on liberalized basis. The exim bank undertakes forfaiting for a minimum value of Rs. 5 lakhs. For this purpose, the exporter has to execute a special Pronote in favor of the exim bank. The exporter will first enter into an agreement with the importer as per the quotation given to him by the exim bank. The exim bank on its part, gets quotation from the forfaiting agency abroad. Thus, the entire forfaiting process is completed by exporter agreeing to the terms of the exim bank and signing the Pronote.
Forfaiting business in India will pick up only when there is trading of foreign bills in international currencies in India for which the value of domestic currency has to be strengthened. This would be possible only with increasing exports. At present, India s share stands at 1.7 percent in the world exports. Perhaps, this will bring a push to the forfaiting market.
Difference Between Factoring and Forfaiting