The Difference Between Factoring and Forfaiting
Factoring and forfaiting may seem like similar terms, and in many cases, people often confuse the two. Those in the economic sectors of almost any business will need to be well versed in forfaiting and factoring.
For instance, you may use medical staffing or a nurse staffing agency for your medical business. The agencies, in turn, use either factoring or forfaiting services to pay you for the hours that their nurses or any other medical staff work with you.
It will be critical to know the difference between factoring and forfaiting when it comes to financing since you don’t want to miss out on money or be unable to pay who you need to.
What Is Factoring?
Factoring is a process that allows you to sell your accounts receivable (AR) and other invoiceable accounts to another party. This may be based on a certain percentage of the sale or a set dollar amount. Factoring usually occurs when there isn’t enough time for the transaction to take place before paying for goods or services is due.
When you factor an account receivable, this also means that you are selling all or part of it in exchange for money right away regardless of whether the payee has paid the invoice. With factoring, interest rates will depend on repayment periods and specific contracts between financing parties.
For example, if you are a manufacturing business, you may issue payments every 30 days. You can go to a factoring company that offers you money for your clients’ invoices that are payable within the next week. You then use this money to pay for expenses or other bills that need to be covered right away.
For payroll, some companies might use factoring since they can’t afford to wait for any expense from whole salary payments to payroll tax. Factoring rates are usually higher than the typical commercial loans you apply for, but this is often compensated with shorter repayment periods and lump-sum payouts. This also means that you will need good credit history before entering into contracts with factoring companies.
What Is Forfaiting?
Forfaiting is the term used when you release a letter of credit in consideration for receiving advance payment. Here’s how it works:
Your trading partner/importer approaches a bank where they request a letter of credit. The bank then issues such a document and holds it until you, the exporter, receive payment. Once you get paid, this releases the letter of credit and triggers the transfer of funds to your account from your trading partners’ (the importer). This method allows for quick payments or cash advances and gives your business access to money without waiting for clients to pay their bills; however, you need good credit history with banks before they issue letters of credits on your behalf.
The main difference between factoring and forfaiting is where you get the money. With factoring, it’s the factoring company that gives you the money, while with forfaiting, this is your trading partners or clients’ bank. Additionally, forfaiting only applies to international or cross-border transactions. It can commonly be used to pay foreign or remote employees.
For the deepest understanding of factoring and forfaiting, you should know the key differences. Knowing these differences may help you determine which is best for your business and financial situation.
Maturity of Receivables
Account receivables with short maturities are the most common kinds of accounts that factoring is concerned with. For example, if you are selling inventory or providing services to customers, factoring can deal with payable invoices within 30 days. The goal of factoring is to get money immediately, which means that the sooner you get paid, the better.
For forfaiting, there’s a different maturity of account receivables. Forfaiting historically referred to accounts receivables of medium-to-long-term maturities. For example, you might have an account receivable that’s payable after 12 months (and much longer).
Extent of Finance
Factoring agencies will generally give debtors 80-90% financing while forfaiting will finance 100%. This is important because whichever you choose, you will need to finance your export invoice by a different percentage than what the financing agency would give. This is where you should consider risks and costs.
Recourse vs. Non-recourse
Non-recourse means that you can still claim the money from the factoring agency if your client doesn’t pay. That’s why interest rates and other fees vary depending on how much risk is involved for both parties.
Recourse policies work differently. If your client defaults, then the financing company will not reimburse you. Instead, it’s on you to claim this money from your client directly.
Factoring can be both with or without recourse, while forfaiting is always non-recourse.
In the case of recourse factoring, you will need to have a good credit history so that the factoring agency is comfortable giving you 80-90% financing. This means that they are taking on much more risk.
This is why forfaiting does not involve any credit check. If your client or trading partner has a bank account (the added party for forfaiting), the debt relies on the credibility of this organization. You can issue them a letter of credit and receive payment.
The cost for factoring goes to the seller or client. The price for forfaiting is at the expense of the overseas buyer. This means that factoring is more expensive for the buyer, while forfaiting is more expensive for the seller.
When you’re choosing a financing option, it’s up to you to decide what’s best. Think about the costs and benefits of each method when considering your current business situation and long-term plans.
Another essential difference between factoring and forfaiting is that when you factor, the factoring agency provides many services depending on what you need.
One of these services includes senior interest rates in cases where your business has good credit history but needs help getting money in a short amount of time. For example, rather than the factoring agency charging you interest rates, they will hold on to your invoice and charge your client higher fees. That way, you get paid faster but at a higher cost.
Forfaiting does not involve any service besides their fee for issuing the letter of credit. You are responsible for collecting payment from your client.
|The client sells its accounts receivables to a factor for immediate payment. The client is liable for unpaid debt.
|Exporter relinquishes/sells their claim to a forfaiter. Exporter not liable when importer fails to pay receivables
|Recourse and non-recourse factoring
|Falls upon the client for recourse factoring
|Falls upon the forfaiter, who relies on the availing bank.
|Seller/Client pays for costs
|Overseas buyer pays for costs
|Administration of sales, and other services vary depending on factoring agency
|No services provided