What's the difference between factoring vs forfaiting?

Export finance is integral to international trade, empowering businesses with the required capital to sustain and navigate financial barriers.

‍Factoring and forfaiting are the most popular or extensively used export financial techniques to ensure a steady cashflow and mitigate risks. 

However, both concepts are interchangeably used by the uninitiated, reinforcing the need to understand the difference between them. 

So, what exactly is factoring and forfaiting?

This article explains how these vendor financing methods' scope, nature, and concept differ. 

What is factoring?

Factoring, also known as invoice financing or accounts receivable financing is a domestic and international trade financing method that allows businesses to receive and secure immediate capital against their account receivables. 

Businesses can sell their outstanding or pending invoices to a third party, known as a factor, at a discounted rate in exchange for an advance on the entire or a percentage of the invoice amount. 

This arrangement offers businesses access to necessary capital instead of waiting for customer payments, ensuring a steady cashflow. 

What is forfaiting?

Forfaiting is a common vendor financing alternative that enables Indian exporters to convert their credit sales into cash sales by receiving instant cash from a forfaiter.

By surrendering their rights to get paid for goods and services delivered to the importer. 

The forfaiter serves as the financial intermediary that facilitates international trade supported by negotiable instruments including promissory notes, letters of credit, or bills of exchange.

Just like factoring, this financial arrangement allows exporters to minimise credit risk and manage cashflow —thanks to instant access to cash rather than waiting to receive payments from their customers. 

6 notable differences between factoring and forfaiting

While factoring and forfaiting remain at the heart of trade and vendor financing, there are a few glaring differences between them.

1. Geography

While factoring is observed in both domestic and international trade, forfaiting primarily applies to international trade financing. 

For example, a small textile company that sells its goods to local retailers can sell its outstanding invoices to a factoring company to access working capital immediately. 

Similarly, a manufacturer that exports machinery to other parts of the world can sell the promissory note it receives from the buyer to a forfaiting company to cover operational expenses. 

2. Process

Factoring deals with the sale of accounts receivables to a third party in return for instant cash; while forfaiting is a financial understanding between a forfaiter and an exporter.

In the latter, the exporter surrenders its authority and rights over trade receivables to access capital. 

3. Maturity of receivables

Factoring is usually part of short-term accounts receivable transactions due within 90 days or less.

On the other hand, forfaiting deals with the sale of medium or long-term accounts receivables. 

4. Nature of goods

Factoring is closely linked with the sale of receivables from common goods and services such as daily supplies, raw material, and consumer products.

On the flip side, forfaiting deals with the sale of capital goods including large equipment or machinery. 

5. Financing percentage

Businesses typically receive around 80-90% financing against the entire value of receivables during factoring.

Forfaiting covers 100% of the total value of exports, making it an attractive financing alternative for businesses. 

6. Negotiable instruments

Negotiable instruments are usually not part of arrangements where factoring is the primary financing method.

As highlighted earlier, forfaiting features various negotiable instruments including promissory notes, letters of credit, and bills of exchange. 

Pros and cons of factoring and forfaiting

Now that you understand the meaning and key differences between factoring and forfaiting, it is a good time to explore the upsides and downsides of both vendor financing models. 

Advantages of factoring

1. Access to capital

One of the most obvious and noticeable advantages of factoring is that it simplifies the trader’s cashflow by providing instant access to capital.

This not only eases the financial burden on traders but also opens up new opportunities for business expansion. 

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Check out these useful tips for securing immediate capital and scaling your business.  

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2. Convenience over traditional loans

Export factoring is a simpler, more accessible option for businesses with limited financial history or collateral.

Unlike traditional financing, approval is easier regardless of credit history, making it an excellent short-term funding solution for various sectors.

3. Less risky for businesses

Since factoring does not require any collateral, it falls under the unsecured financing umbrella. This allows businesses to operate without worrying about losing their assets.

That said, failure to comply with the agreed terms could impact credit ratings, damage customer relationships, and lead to a period of financial stability. 

Disadvantages of factoring

While factoring offers several benefits, unfortunately, it isn’t always the best option for all business types. Let’s understand why. 

1. Lowered profit margin

The factor (financer) pockets a certain percentage of the invoice amount as commission.

Although the cut could range between 1-3% of the invoice, it can lower a business’s profit margins in the long run. 

2. Customer’s credit scores could lead to rejection

Although the business’s creditworthiness isn’t necessarily in question, their invoice factoring request can be denied if their customer’s credit rating and scores aren’t satisfactory. 

3. Hidden costs

Considering the complex nature of the financial world, many factoring companies can take undue advantage of their customers by including hidden costs in the form of late payment fees, processing fees, and application fees. 

Therefore, it is crucial to double-check with factoring entities regarding additional costs apart from the quoted factoring rate to ensure you stay clear from an unpleasant surprise.

Pros and cons of forfaiting

Advantages of forfaiting

1. Risk mitigation

Since forfaiting primarily involves transferring non-payment risk from an exporter to the forfaiter (financier), it allows exporters to focus on their core business activities instead of unproductive tasks including payment collection. 

2. Instant settlement

One of the most distinct advantages of forfaiting is that it allows exporters or businesses to receive an upfront payment for their goods and services rather than waiting for customer payments. 

3. Flexible vendor financing model

Forfaiting can be tailored to meet unique business requirements and does not involve stringent paperwork making it a suitable financing for every type of business. 

Since forfaiting paves the way for seamless international trade, it opens up lucrative opportunities for exporters to tap into new and unexplored markets. 

Disadvantages of forfaiting

1. Not ideal for short-term trade agreements

Forfaiting may not suit small businesses due to the higher transaction costs and limited scope and is generally used y for medium to large-scale and long-term transactions. 

2. High costs

Although forfaiting eliminates credit risks for exporters, the associated costs are higher than the financing alternatives offered by traditional financial institutions, including banks.

Forfaiters justify the higher costs by absorbing more risk compared to conventional lenders.

3. High dependency 

Many businesses are overly dependent on forfaiting to meet their financial requirements due to its convenience and other aforementioned benefits.

Although this approach may work in the short-term, it can often lead to a single monetary source which isn’t feasible in the long run. 

Factoring or forfaiting? What’s right for your business?

Picking between forfaiting and factoring primarily depends on several factors including the type of business, business size, level of risk, and type of transactions. 

Below, we have listed down a few scenarios where each of these vendor financing models can streamline cashflow management and support business operations. 

Opt for factoring if:

• You have a small business and predominantly deal with smaller sales transactions
• You want to secure instant cash to meet your short-term financing requirements
• You are finding an effective solution to manage accounts receivable
• Your customer base is a mix of domestic and international buyers

Opt for forfaiting if:

• You have a medium to large-size business dealing with larger transactions
• You require medium to long-term financing 
• A significant chunk of your customers live abroad

Parting notes: factoring vs. forfaiting

Both, export factoring and forfaiting are among the most popular international trade financing solutions worldwide.

These financing alternatives unlock the doors to consistent cashflow, shielding businesses from non-payments and delayed payments.

That said, businesses need to understand the nuances and differences between factoring and forfaiting before they can decide which financing model to opt for. 

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