Introduction
Factoring and forfaiting are concepts related to finance. Often businesses sell their goods and services to customers on credit. The businesses are responsible for collecting the payments from customers later. However, sometimes businesses go through financial situations where they require quick cash. They can take certain steps to gather the money. Some measures are getting a loan, factoring, and forfaiting. Loans require businesses to put down collateral in exchange for money. If the business does not want to put down collateral, it can use the other two methods.
In both factoring and forfaiting, the business sells accounts receivables to a third party at discounted rates. In factoring, the seller receives an advance payment for the invoices and receives the rest after the customers pay the debt. In forfaiting, the exporter gives up the right to claims in exchange for quick cash.
These two methods may seem extremely similar, but they have their differences. This article will explore those differences.
For a better understanding of the article, certain terms uncommon outside the subject are described below-
- Accounts receivable- sometimes customers purchase goods and services from a company using credit. The money owed to a business from such purchases is accounts receivable.
- Invoice- a list containing information about goods and services provided and a statement containing the sum to be paid.
- Recourse- when customers do not pay the owed amount, the seller becomes responsible for paying the amount to the financier company.
- Non-recourse- the financier company is responsible for losses related to non-payment.
Factoring vs Forfaiting
Factoring is an option for businesses to acquire quick cash. The business sells its invoices at a discounted rate to a factor. The factor becomes responsible for collecting payment from customers. However, in case of non-payment, the business becomes responsible for paying the debt to the factoring company. Factoring offers companies short-term and long-term solutions in terms of financing.
Forfaiting is a similar method. International companies are the primary users of this method. The companies sell their invoices to a forfaiter at a discounted rate. However, in forfaiting, the companies also relinquish their control over the invoices. Hence, they are not responsible for collecting payment from customers or paying the forfaiter in case of non-payment from customers. The forfaiting company assumes the risk of non-payment. Forfaiting offers long-term solutions for companies.
Difference Between Factoring and Forfaiting in Tabular Form
| Parameters of Comparison | Factoring | Forfaiting |
| Meaning | Factoring is a method through which companies can convert their receivables into ready cash | A method in which the exporter gives up the right to claims in exchange for cash |
| Maturity of receivables | Account receivables of short maturities | Account receivables of medium to long-term maturities |
| Traded goods | Ordinary goods | Capital goods |
| Finance | Upto 80-90% | 100% |
| Type | Recourse and non-recourse | Non-recourse |
| Expense | The seller bears the cost of factoring | The forfaiter bears the cost of forfaiting |
| Negotiable instruments | None | Present- bills and promissory notes |
| Secondary market | No | Yes |
| Responsibility for collecting payment | The seller is responsible for paying the debt if the customers do not pay the factor | The exporter is not responsible for paying the debt if the customers fail to do so |
| Notification | The process can happen with or without notification | Forfaiting happens with a notification |
| Solution | A short-term or long-term solution | Long-term solution |
What is Factoring?
A financial method in which a company sells its accounts receivables at a lower price to a third party is factoring. Other names of factoring are invoice factoring and accounts receivable financing. The process of factoring requires the involvement of three parties, a debtor, a client, and the factor. The debtor is the person who bought goods from the company using credit. The seller is the business responsible for providing goods and services. The factor is the third-party financier who buys the accounts receivables.
Factoring helps businesses to receive quick cash. This method is useful for small businesses and start-ups, as they have a hard time getting loans from traditional forms of financing. Since factoring is not exactly a loan it does not require any forms of collateral.
Process of Factoring
The process of factoring works as follows,
Step 1: Customers buy goods and services from a business on credit.
Step 2: The business sells its accounts receivable at a discounted rate to a factor. This factoring company is now responsible for collecting the payment from the customers.
Step 3: The factoring company makes an advance payment to the seller.
Step 4: The customers make the payment for goods on the due date.
Step 5: The factoring company collects payments from customers and gives a percentage to the business as payment.
Pros of Factoring
Increase In Cash Flow For The Business
When customers purchase goods and services on credit, they will take a certain amount of time to make the payments. By selling the invoices through factoring, the companies can receive payments for these invoices quickly. They do not have to wait for the customers to pay back the amount. Through this, a company can improve their cash flow, which in turn helps them meet all their necessary financial requirements.
Decreased Risk For Companies
Allowing customers to purchase goods and services comes with a certain amount of risk. They may not always pay back the amount. Through factoring, a business is selling the invoices to a factor. This factoring company is now responsible for collecting payments from customers. Hence, factoring helps companies reduce the risk of non-repayment from their customers.
More Financial Flexibility
By selling off the invoices, the company receives extra cash flow. This cash can help businesses by providing financial stability. They now have cash for expansion, investment, buying or upgrading equipment, etc.
Improves a Company’s Creditworthiness
Factoring helps businesses to make quick cash. It keeps the cash flow going. This quality helps companies to avoid debt. In addition, factoring also helps companies to avoid non-repayment by customers. Therefore, the method helps to increase a company’s creditworthiness among possible lenders.
Decreases Administrative Burden
By selling the invoices to a factoring company, the seller is now free of the burden to collect payments from customers. This benefit helps businesses to have more free time. They can also use their resources more efficiently. Therefore, factoring helps companies to devote their time and resources to improving their company without worrying about additional burdens.
No Need for Collateral
Factoring does not require the seller to have collateral. Businesses can sell their invoices without any hassles. This process helps small businesses get financial assistance without trying for loans. They will receive the needed cash to keep their business going.
No Repayment Schedule
Businesses can sell their invoices whenever they want. There is no fixed schedule for selling invoices. Hence, they can choose to sell their invoices when they need extra cash.
Helps Eliminate Debt
Factoring helps companies to acquire extra cash when they require it. It helps companies escape taking out loans. In addition, since factoring is not a loan, there is no debt acquired through the process. Hence, factoring helps companies to avoid going into debt.
Cost-Effective Method
Factoring is a cost-effective method. Compared to other forms of extra financing, it is easier to go through the process of factoring, without incurring extra expenses.
Cons of Factoring
No Control Over Credit From Customers And Their Collections
Through factoring, businesses sell their invoices to a factoring company. This company then becomes responsible for collecting payments from the customers. Hence, the seller loses connection with the customers. When this situation happens, the seller cannot oversee the repayments and ensure that the customers make their timely payments.
Less Profit
Factoring companies help by buying invoices and taking on the duty of collecting the repayment from customers. However, this service comes at a price. The sellers will have to pay a fee to the factoring companies. Usually, this fee will be a portion of the profits from the customer's repayments. Hence, factoring can lead to fewer profits.
Need for Discreetness
If a company is engaging in factoring, it gives the wrong message to its customers, suppliers, and partners. It means that the company does not have enough finances and needs extra help. Hence, companies engaging in factoring need to be discreet.
Not Available to All
Factoring services are available to businesses that sell their goods and services to other businesses. It is not an option for retail businesses.
Risk Of Customers Not Paying For The Services
When factoring companies take over the invoices, they become the receivers of customer payments. However, if the customers fail to make the necessary payments, the seller is responsible for paying the amount to the factoring company.
Less Opportunity for Negotiation
Factoring companies have set payment terms. The sellers have to abide by these rules if they want to sell the invoices. Hence, the customers will also have to abide by the rules of the factoring companies. This situation can affect the relationship between the seller and the customers.
Not Available for all Assets
Factoring companies take only receivables. Sometimes businesses need to sell other assets like equipment, inventory, etc. Factoring is not useful in these situations.
Creditworthiness
Factoring companies research the creditworthiness of the customers. If the business's customers have low creditworthiness, the factoring company can refuse to provide their services to the seller.
Privacy Issues
Factoring companies require the financial information of seller and their customers. This requirement can cause privacy issues.
What is Forfaiting?
Forfaiting is a method similar to factoring. The exporter (seller) sells their claim to receivables to a forfaiter at discounted rates to receive instant cash. The difference between factoring and forfaiting is that the seller relinquishes his rights to receive payments from the customers.
Forfaiting is helpful for international trade. It can facilitate trade between countries of different currencies. Forfaiting uses negotiable instruments like bills and promissory notes.
Pros of Forfaiting
Reduces Risk of Non-Payment
In forfaiting, the exporter no longer needs to collect the debt from the importer. The forfaiter takes up the credit risk.
More Cash Flow
Through forfaiting, companies sell their claims to a forfaiter. This method helps them to acquire instant cash.
More Financing
Not all companies have the option of getting traditional forms of financing. Forfaiting helps these companies receive extra financing.
Flexibility
Forfaiting is available for various trade transactions. Companies can use it for the export of goods and services.
Speed and Efficiency
In forfaiting, the exporter gives up control over the claims and the forfaiter assumes control. Hence, there is no need for other steps like extensive credit analysis and documentation.
No Collateral
Unlike loans, forfaiting does not require the exporter to put up collateral. This benefit is useful for companies that do not have assets for collateral.
Less Burden on Administration
There is less need for complex documentation in forfaiting. Hence, the process is easier on the companies’ administration.
Cost-Effective
Forfaiting gives companies a chance to acquire quick financing. In addition, forfaiting companies charge fewer fees for the process than banks do for financing.
Confidential
The information about companies involved is forfaiting is private. Hence, it helps protect the image of companies.
Cons of Forfaiting
Availability
The primary use of forfaiting is in the export of goods and services. It does not cater to all industries.
Creditworthiness
Forfaiting companies make their decision based on the creditworthiness of the buyer. If the buyer has low credit scores, the forfaiter could refuse to help the exporter.
Transaction Size
Forfaiting requires a high minimum transaction size. Therefore, it is difficult for small and medium-sized companies to avail of forfaiting.
Less Geographic Reach
Forfaiting companies usually do transactions with international companies. Hence, it may not be an option for companies that operate only within their own country.
Complex
Forfaiting can be a complex process. It may require the involvement of multiple parties, insurance companies, banks, etc.
Limited Control
The exporter relinquishes control over the invoices. This process can limit the exporter's control over the transactions with customers.
Time-Consuming
Forfaiting requires extensive documentation and many other actions. Hence, it can become a time-consuming process.
Risk of Non-Payment
The method of forfaiting relaxes the seller from any credit risk. However, if the customer does fail to pay the forfaiter, the seller will have to bear certain consequences.
Main Differences Between Factoring and Forfaiting (in Points)
- Factoring is a method through which companies sell their invoices in exchange for cash. Forfaiting is a situation in which companies relinquish their right to invoices.
- Factoring involves the seller receiving advance cash payment when selling the invoice and receiving the rest when the customers pay the factor. In forfaiting, the exporter receives instant cash for the invoices.
- In factoring, the seller is responsible for paying the factor in case the customer fails to make payments. In contrast, the seller is exempt from any responsibility to pay the forfaiter in case of non-payment.
- Factoring provides a short-term and long-term solutions to companies. Forfaiting only provides a long-term solution.
- Factoring deals with the transaction of ordinary goods. Forfaiting deals with capital goods.
Conclusion
In short, factoring and forfaiting are similar yet different methods for acquiring financing. In both methods, companies sell their invoices to a third party at a discounted rate. In factoring, the seller receives an advance payment and the rest after the customers make their payment. The seller is responsible for the non-payment of the customers. In forfaiting, the company gives up control over the invoices. The seller is no longer responsible for non-payment of customers.
References
- https://economictimes.indiatimes.com/definition/accounts-receivable
- https://testbook.com/key-differences/difference-between-factoring-and-forfaiting
- https://www.nerdwallet.com/article/small-business/recourse-factoring-vs-non-recourse-factoring
