What it means
Exporters selling capital equipment often have to offer their customers extended payment terms, sometimes two to seven years, which ties up an enormous amount of cash. Forfaiting converts those long-dated promises into money today, usually within days of shipment.
The receivable is normally evidenced by bills of exchange, promissory notes or a letter of credit, which makes it easy to transfer. The defining feature is that the sale is without recourse.
Once the forfaiter buys the paper, the exporter is off the hook for non-payment, political upheaval, currency controls or bank failure in the buyer's country. This is what separates forfaiting from ordinary invoice discounting, where the lender usually claws money back if the customer defaults.
Because the forfaiter carries all that risk, it wants comfort from a bank in the importer's country. In practice the importer's bank guarantees the notes, either by adding an aval (a guarantee written directly on the instrument) or by issuing a separate guarantee.
The stronger that guarantee, the finer the discount rate the exporter is offered. Pricing has two main components: a discount rate applied for the life of the paper, and fees such as a commitment fee charged between the deal being agreed and the goods actually shipping.
The all-in cost is usually higher than domestic bank borrowing, which is the price of removing risk from the balance sheet entirely. Forfaiting is typically used for larger single transactions in hard currencies, while factoring suits a continuous flow of short-term invoices.
Many exporters use it selectively for sales into markets where they would otherwise refuse to give credit at all.
In practice
Real-world examples.
Example
A Dutch maker of bottling lines sells a $4,000,000 plant to a buyer in Central Asia on four-year terms. It forfaits the bank-guaranteed notes immediately after shipment, books the sale as a cash transaction and never carries the country risk on its balance sheet.
Example
A turbine manufacturer wins a tender only because it can offer five-year credit. Its treasury team obtains an indicative forfaiting quote before bidding, then prices the discount into the contract so the extended terms cost the manufacturer nothing.
Example
A mid-sized rail signalling supplier has three large export receivables maturing in different years. It forfaits the two backed by strong bank guarantees, keeps the third on its own books, and uses the proceeds to fund a new production line without new borrowing.
Formula
Calculation
Discount = Face value x Discount rate x (Days / 360). Net proceeds = Face value - Discount - Fees. Effective cost = (Discount + Fees) / Net proceeds.
An equipment maker ships machinery worth $1,000,000 and holds a promissory note payable in 360 days, guaranteed by the importer's bank. A forfaiter offers a discount rate of 7% a year plus a 1% commission.
Discount = 1,000,000 x 0.07 x (360 / 360) = $70,000. Commission = 1,000,000 x 0.01 = $10,000.
Net proceeds = 1,000,000 - 70,000 - 10,000 = $920,000, received within days of shipment.
Total cost of 70,000 + 10,000 = $80,000 on proceeds of $920,000 is an effective cost of 80,000 / 920,000 = 8.7% for the year. The exporter compares that with holding the receivable for a year and carrying the risk of a customer 6,000 miles away.Case study
Seen in the real world.
Consider Vellmark Process Systems, an illustrative and entirely fictional builder of industrial dryers. It had been turning away business from two promising overseas markets because its board refused to accept multi-year credit exposure to unfamiliar buyers.
The finance director arranged a forfaiting facility with a specialist house. On the next contract, worth $3,000,000 on three-year terms, the importer's bank avalised six semi-annual notes and the forfaiter bought them for roughly $2,640,000, giving Vellmark its cash within a fortnight of shipment.
The gross margin on that order was lower than on a domestic sale, but the company had no receivable, no currency exposure and no collection risk. In this fictional illustration, Vellmark's board came to treat the forfaiting cost as a sales expense, quoted it into every export price and doubled its overseas order book over two years.
Watch out
Common mistakes.
- Confusing forfaiting with factoring, when factoring typically covers a rolling book of short-term invoices with recourse and forfaiting covers single medium-term receivables without it.
- Agreeing a sale on extended terms first and only then asking what forfaiting will cost, which leaves the discount eating into a margin that was already fixed.
- Assuming the exporter is fully protected, when the forfaiter can still come back if the underlying documents are defective or the goods were never properly delivered.
Questions
People also ask.
Is the discount rate the whole cost?
No, you should add commitment fees, documentation charges and any grace days the forfaiter builds into the calculation before comparing it with other funding.
Does forfaiting remove the receivable from the balance sheet?
Generally yes, because the sale is without recourse and the risks and rewards pass to the forfaiter, though the accounting treatment should always be confirmed with your auditor.
What makes a deal easy to forfait?
Hard-currency paper, clean transferable instruments, a well-known guaranteeing bank and a country the forfaiter already has appetite for.
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