Factoring as a financial service is of recent origin in India, introduced in the early 90s and it is yet to pick up momentum. If the purchaser of the goods delays payment it will result in locking up of working capital funds for the exporter. Further, in this competitive environment, an exporter has to keep in mind the cost of borrowing also while pricing his commodity. To provide an alternate route for availing finance against receivables comparatively at a cheaper cost and also with some more advantages, factoring has been introduced in India.
'Factor' (organisation) is an authorised transactor of business for another. In the absence of concise definition, factoring may be defined as an arrangement for financing a company's business against the unpaid invoices drawn in favour of the customers and in which the factor becomes responsible for all credit control, sales ledger administration and debt collection activities. In a full service factoring parlance, if the debtor fails to pay the dues to the factor, by the terms of arrangement, the factor has to absorb the losses. The transition from simple sale on a consignment basis through the agents, gradually developing into assuming additional responsibilities by the agents led to the development of modern factoring.
First attempt was made to define uniform laws for International factoring by International Institute for Unification of Private Laws (UNIDROIT), Canada. It was agreed by UNIDROIT, in general, that the term factoring meant an arrangement between a factor and his client (seller) which, included, at least, two of the following services:
DEBT ADMINISTRATION (management of sales ledgers and collection of debts)
Under a factoring contract the sales ledger of the client company will be managed by the factor. The client will be saved of the administrative cost of book keeping, invoicing, credit control and debt collection, as the factor will be providing professional service of sales ledger administration. All the parties involved in the transaction will be relieved of the work of follow-up of the debt collection. Service charges payable by to the factor by the client will be more than compensated by the savings effected in the expenditure for maintenance of office staff for follow up and collection of debt.
CREDIT PROTECTION:
Factors as professionals will have the facility for credit intelligence to enable them to assess credit risk and advise their clients accordingly. The staff of the factor is trained in the assessment of credit worthiness and will have access to extensive information on the financial standing and credit rating of individual customers. Over a period of time they would have built up an extensive data base on the credit status of the individual buyers of goods and services. These data can be accessed by the users for a fee.
FACTOR FINANCING:
Although not an essential one in other countries, in India, factor financing has been an essential service provided by a factor. Factor financing involves advancing of funds to the client against debts which the factor has purchased. In most of the cases the factor will be willing to advance to the extent of 75% to 80% of the outstanding debts.
With the above services rendered by a factor, factoring can be defined:
“a continuing legal relationship between a financial institution (the Factor) and a business concern (the client) selling goods or providing services to trade customers (the Customer) on open account basis whereby the Factor purchases the client's book debts (receivables) either with or without recourse to the client and in relation thereto controls the credit extended to customers and administers the sales ledgers.â€
TYPES OF INTERNATIONAL FACTORING:
Depending upon the need of the exporter-client and his price bearing capacity various types of international factoring are in vogue, the principal amongst them are:
1. TWO FACTOR SYSTEM:
In this system, the transaction is based on operations of two factoring companies in two different countries involving four parties: i) exporter ii) importer iii) export factor in exporter's country and iv) importer factor in importer's country.
Various stages are:
the exporter approaches the export factor with various business information which inter alia may include type of business, name and address of the debtors in various importing countries, annual expected turnover to each country, number of invoice/credit notes per country, payment term and line of credit requirement for each debtor.
based on the information furnished above, the export factor would contact his counterpart (import factor) in different countries to assess the credit worthiness of the various debtors.
the import factor makes a preliminary assessment as to his ability to give credit cover to the principal debtors. If the assessment by the import factor is positive he would indicate the quantum of coverage coupled with required commission and other conditions for cooperation, otherwise the matter is referred back to export factor for alternatives.
Agreement is signed between the exporter and the export factor. After shipment of goods by the exporter two copies of the invoice are sent to the export factor who then makes an agreed prepayment to the exporter and sends the invoice to the import factor.
Import factor in turn collects the debts and remits the proceeds to export factor. In case if the payments are not received from any of the debtors at the end of agreed period (normally 90 days from the due date) the import factor has to pay the amount of the bill from out of his own resources. However this obligation will not apply in case of any disputes regarding quality, quantity terms and conditions of supply etc.
Finally on receipt of the proceeds of the debts realised the balance held with the export factor (20 - 25%) will be released. Factoring fee will be debited to the exporters account and the export factor remits the mutually agreed commission to his importing counterpart.
Thus the main functions of the export factor relates to: assessment of the financial status of the exporter assessment of the financial status of the importer through import factor prepayment of the receivables to the exporter after proper documentation follow up of recovery with the import factor sharing commission with the import factor
Correspondingly the import factor will be engaged in:
maintaining the details of sales to debtors in his country
collection of debts from the importers and remitting the proceeds to the export factor
providing credit protection in case of financial inability by any of the debtors. Two factor system is probably the best mode of providing the most effective factoring facility to a prospective client.
2. SINGLE FACTORING SYSTEM:
With a view to obviating the constraints in the two-factor system single factoring system has been introduced by some of the factoring companies, primarily in FACTORS CHAIN INTERNATIONAL GROUP.(FCI)
Under this system a special agreement is signed between two factoring companies in the exporting and importing countries on conditions for single factoring whereby as in the two factor system the credit cover is provided by the import factor. If the export factor is not in a position to realise any debt within 60 days from the due date he requests the importing counterpart to undertake the collection responsibility, simultaneously informing the defaulting debtor about the assignment of the debt to the latter. It is now the responsibility of the import factor to continue the collection efforts and initiate legal proceedings, if necessary. In case the debt remains outstanding for more than 90 days from the due date the import factor has to remit the amount by virtue of his credit risk undertaking to the export factor.
Pricing under this system is much lower compared to that of the two factor system. The variation is introduced upto the extent that the role of the import factor as a collection agency starts only if there is a potential threat of non-recovery. The import factor does not maintain any book of account of the exporter but acts on the information of the export factor. Thus in order to make the mechanism effective, a perfect coordination and co-operation bases on mutual trust and faith must exist between two factoring agencies.
3. DIRECT EXPORT FACTORING:
Under this system only one factoring company is involved i.e., export factor, which provides all elements of service of factoring namely finance to exporter, maintenance of sales ledger and collection of debts from the importers, credit protection in case of financial inability on part of any of the importers. The basic advantage of this system is the obvious reduction in pricing structure coupled with uniform and quick service.
4. DIRECT IMPORT FACTORING:
Under this system, the seller will choose to work directly with a factor in the importers country. The import factor is responsible for sales ledger, administration, collection of debts and providing bad debt protection under the agreed level of risk coverage. The disadvantage of the system is the lack of proximity between the exporter and the import factor, which may lead to problems at a later stage.
ADVANTAGES OF EXPORT FACTORING:
The distinct advantage of a factoring transaction over other methods of finance provided to an exporter can be summarised as under:
immediate finance upto a certain percentage (say 75 to 80%)
no necessity for covering the transaction by a letter of credit
credit checking of all the prospective debtors in importing countries through Factors counterparts in importing countries or established credit rating agencies
maintenance of entire sales ledger of exporter including asset management
bad debt protection upto 100% on all approved sales to agreed debtors ensuring total predictability of cash flow
undertaking cover operations to minimize potential losses arising from exchange rate fluctuations and
consultancy services in areas relating to special conditions and regulations as applicable to the importing countries.
FORFAITING - AN EXPORT FINANCE OPTION
“Forfaiting is a mechanism of financing exports. By discounting export receivables evidenced by bills of exchange or promissory notes without recourse to the seller carrying medium to long terms maturities on a fixed rate basis (discount) upto 100 percent of the contract value.â€
The word 'forfait' is derived from the French word 'a forfeit' which means the surrender of rights.
Simply put, forfaiting is the non-recourse discounting of export receivables. In a forfaiting transaction, the exporter surrenders, without recourse to him, his rights to claim for payment on goods delivered to an importer, in return for immediate cash payment from a forfaiter. As a result, an exporter in India can convert a credit sale into a cash sale, with no recourse to him or to his banker.
Eligibility
All exports of capital goods and other goods made on medium to long term credit are eligible to be financed through forfaiting.
Working
Receivables under a deferred payment contract for export of goods, evidenced by bills of exchange or promissory notes, can be forfaited.
Bills of exchange or promissory notes, backed by co-acceptance from a bank (which would generally be the buyer's bank), are endorsed by the exporter, without recourse, in favour of the forfaiting agency in exchange for discounted cash proceeds. The banker's co-acceptance is known as avalisation. The co-accepting bank must be acceptable to the forfaiting agency.
Role of Exim Bank
The role of Exim bank will be that of a facilitator between the Indian exporters and the overseas forfaiting agency.
On a request from an exporter, for an export transaction, which is eligible, to be forfaited, Exim Bank will obtain indicative and firm forfaiting quotes - discount rate, commitment and other fees - from overseas agencies.
Exim Bank will receive avalised bills of exchange or promissory notes, as the case may be, and send them to the forfaiter for discounting and will arrange for the discounted proceeds to be remitted to the Indian exporter.
Exim Bank will issue appropriate certificates to enable Indian exporters to remit commitment fees and other charges.
Exim Bank has been authorised by the Reserve bank of India vide AD (GP Series) Circular No. 3 dated February 13, 1992, to facilitate export financing through forfaiting.
Cost
A forfaiting transaction has typically three cost elements;
Commitment fee
A Commitment fee is payable by the exporter to the forfaiter for a latter's commitment to execute a specific forfaiting transaction at a firm discount rate within a specified time (normally not more than one year).
The commitment fee generally ranges between 0.5 percent and 1.5 percent per annum of the unutilised amount to be forfaited and is charged for the period between the date the commitment is given by the forfaiter and the date the discounting takes place or until the validity of the forfait contract, whichever is earlier.
The commitment fee is payable regardless of whether or not the export contract is ultimately executed.
Discount fee
Discount fee is the interest cost payable by the exporter for the entire period of credit involved and is deducted by the forfaiter from the amount paid to the exporter against the avalised promissory notes or bills of exchange.
The discount fee is based on the relevant market interest rates as reflected by the prevailing London Inter-bank Offered Rate ('LIBOR') for the credit period and currency involved, plus a premium for the risks assumed by the forfaiter.
The discount rate is applied to the aggregate principal and interest due on the debt instrument on its maturity, to arrive at the payout to the exporter. The discount rate is established at the time of executing a forfait contract between the exporter and the forfaiting agency.
Documentation fee
Generally, no documentation fee is incurred in straightforward forfait transactions. However, if extensive documentation and legal work is necessary, a documentation fee may be charged.
Other costs
Exim Bank will charge a service fee for facilitating the forfaiting transaction which will be payable in Indian rupees.
There may be additional costs levied by a forfaiter, such as handling charges, penalty etc. However, these costs are transaction-specific and will be specified, where applicable.
Costs that need to be transferred to the overseas buyer
As per Reserve Bank of India's AD (GP Series) Circular No.3 dated February 13, 1992, discount fee, documentation fee and any other costs levied by a forfaiter must be transferred to the overseas buyer. Commitment fee should also be passed on to the overseas buyer to the extent possible.
The exporter should finalise the export contract in a manner which ensures that the amount received in foreign exchange by the exporter after payment of forfaiting discount and other fees is equivalent to the price which he would obtain if goods were sold on cash payment terms.
Duty drawback
Duty drawback will be computed only on FOB cost of goods i.e. invoice value less freight, insurance, if any, and forfait discount and other related fees.
Benefits to an exporter
Converts a deferred payment export into a cash transaction, improving liquidity and cash flow
Frees the exporter from cross-border political or commercial risks associated with export receivables.
Finance upto 100 percent of the export value is possible as compared to 80-85 percent financing available from conventional export credit programmes.
As forfaiting offers without recourse finance to an exporter, it does not impact the exporter's borrowing limits. Thus, forfaiting represents an additional source of funding, contributing to improved liquidity and cash flow.
Provides fixed rate finance; hedges against interest and exchange risks arising from deferred export credit.
Exporter is freed from credit administration and collection problems.
Forfaiting is transaction specific. Consequently, a long term banking relationship with the forfaiter is not necessary to arrange a forfeiting transaction.
Exporter saves on insurance costs as forfaiting obviates the need for export credit insurance
Simplicity of documentation enables rapid conclusion of the forfaiting arrangement.
Duration of receivables eligible for forfaiting.
Normally between 1 year and 5 years.
Currency in which contract must be executed to be eligible for forfaiting
The export contract can be executed in any of the major convertible currencies
e.g. US Dollar, Deutsche mark, Pound Sterling, Japanese Yen.
FORFAITING - OPERATING PROCEDURE
Indian exporter initiates negotiations with prospective overseas buyer with regard to order quantity, price, currency of payment, delivery period and credit terms.
Exporter approaches Exim Bank to obtain an indicative forfaiting quote from the forfaiting agency. For this purpose, the exporter is required to provide the following information -
Name and address of foreign buyer Country to which exports are to be made
Name of the guarantor bank (i.e. aval), if known to the exporter Nature of goods Order quantity
Amount of order - base price, interest rate Delivery period and repayment schedule
Name of the authorised dealer who will handle the export transaction for the exporter in India.
Exim Bank obtains indicative quotes of discount, commitment fees and documentation fees if any, and communicates these to the exporter.
Exporter finalises the terms of the contract with the buyer. The final export offer is structured in a manner which ensures that the amount received in foreign exchange by the exporter after payment of forfaiting discount and other fees is equivalent to the price which he would obtain if goods were sold on cash payment terms.
If the terms are acceptable to the overseas buyer, the Indian exporter informs Exim Bank accordingly and requests the Bank to obtain a firm quote from the forfaiting agency.
Exim Bank obtains a firm quote from the forfaiting agency and conveys this information to the exporter and his authorised dealer, with a request to the exporter to confirm acceptance of the forfaiting terms within a specified time limit.
Indian exporter confirms acceptance of forfaiting terms to Exim Bank. The exporter will enter into a commercial contract with the overseas buyer and also execute a forfaiting contract with the forfaiting agency through Exim Bank.
On execution of the forfaiting contract, Exim Bank issues -
A certificate to the exporter with a copy of the authorised dealer, regarding the commitment fee to be paid by the exporter to the forfaiting agency. This certificate will enable the exporter to remit commitment fees to the forfaiting agency, in accordance with the schedule indicated in the forfaiting contract. In terms of the Reserve Bank of India guidelines governing forfaiting contracts, commitment fees will be regarded as being analogous to bank charges, and will not be required to be mentioned in the GR from or shipping bill prepared by the exporter, subject to the commitment fee not exceeding 1.5% of the contract value.
Certificate to the exporter detailing the discount payable to the forfaiting agency, to enable the Indian Customs authorities to verify deductions towards forfaiting discounts declared by the exporter on the GR form and shipping bill.
The Indian exporter ships the goods as per the schedule agreed with the overseas buyer. The forfaiting transaction will be reflected in the following three documents associated with an export transaction, in the manner suggested below -
Invoice
Forfaiting discount, commitment fees, etc. need not be shown separately; instead, these could be built into the FOB price, stated on the invoice.
Shipping Bill and GR form
Details of the foraiting costs will be included alongwith the other details, such as FOB price, commission insurance, normally included in the "Analysis of Export Value" on the Shipping Bill. The claim for duty drawback if any, will be certified only with reference to the FOB value of the exports stated on the shipping bill.
The export contract will provide for the overseas buyer to furnish avalised bills of exchange or avalised promissory notes.
If the contract provides for bills of exchange, the exporter will draw a series of bills of exchange and send them along with shipping documents to his banker for presentation to importer for acceptance through latter's banker. Importer's banker will hand over shipping documents to importer against acceptance of bills of exchange by the importer and signature of aval. Avalised and accepted bills of exchange will be returned to exporter through his banker. Exporter will endorse avalised bills of exchange with the words "Without Recourse" and forward them through his banker to Exim Bank, which in turn will send them to the forfaiting agency.
If promissory notes are provided for in the export contract, then the exporter will
require the importer to prepare a series of avalised promissory notes, as agreed. On shipment, the exporter's bank sends the shipping documents to the importer's bank for transmission to the overseas buyer. Importer's banker will hand over shipping documents to importer against avalised promissory notes issued by the importer. Avalised and accepted promissory notes will be forwarded to the exporter through his banker. The Indian exporter endorses the avalised promissory notes with the words "Without Recourse" and forwards them through his bank to Exim Bank, which in turn will send them to the forfaiting agency.
The forfaiting agency effects the payment of the discounted value, in accordance
with Exim Bank's instructions, after verifying the aval's signature, and other
particulars. Normally, Exim Bank will direct the forfaiter to credit the payment to the nostro account of the exporter's bank in the country where the forfaiter is based. The bank receiving the discounted proceeds will arrange to remit the funds to India. The exporter will be issued a Certificate of Foreign Inward Remittance. The GR form will also be released.
An export contract, which provides for more than one shipment can also be
forfaited under a single forfaiting contract. However, where the export is effected in more than one shipment, avalised promissory notes / bills of exchange in respect of each shipment could be forfaited, subject to the minimum value requirement laid down by the forfaiter.
On maturity of the bills of exchange/promissory notes, the forfaiting agency presents the instruments to the aval for payment.
