Finance: Forfaiting-Part III

In earlier articles, we had discussed what is forfaiting and how it works.   In this concluding article, we shall examine the benefits of this system of international trade finance.

The benefits or advantages of Forfaiting may be studied in relation to the parties to the transaction.

Benefits to the Exporter(Seller): 

1)  Elimination of Risk:  One of the major advantages or benefits of Forfaiting is the elimination of risks, to a large extent, mainly of a political, financial, and commercial nature.

Political risk may arise on account of factors like War, Civil War, Disturbances, lack of foreign exhange reserves, restrictions on foreign trade, etc.  

Transfer or payments risk  may arise on account of currency conversion issues.  

 Commercial risk may arise on account of the insolvency or bankruptcy of the importer or even the importer’s Bank, or disputes relating to the merchandise, etc.   Another risk is that of interest rate changes and currency rate fluctuations.

2)  Improves Cash Flows:  One of the major parameters for judging the health of a company is the soundness of its cash flows.   Especially for small and growing concerns, timely conversion of their inventories and recievables ensures a steady supply of internal finance for the purpose of faster turnover and higher sales.

Forfaiting helps an exporter convert his credit sales into cash immediately.   That too, to the full extent of the bill amount.   This type of financing provides much needed maneuverability to the exporter in relation to his future plans, and to be aggressive in the pursuit of his business goals.

3)  Gives Competitive Edge:  In a highly competitive environment, buyers are always looking for value for money, and a good deal.

Often, exporters are under pressure to afford credit to their foreign buyers.   Forfaiting comes to the aid of the exporters by encashing their export documents for the full value, while allowing the exporters to export their merchandise on credit.   This adds to the competitive edge of the exporter.

4)  Opens New Markets:  Often, exporters are constrained in their efforts on account of the uncertainty of payments for exports made.   Forfaiting relieves the exporter of this burden, as forfaiting transactions are always without recourse to the seller(exporter).   That is, the forfaiter cannot demand repayment from the exporter in the event of the importer’s default.

5)  Administrative and Legal Issues:  Forfaiting relieves the exporter of the time consuming and sometimes onerous responsibility of administrative and legal work in connection with realization of export proceeds.   The ‘headaches’ associated with export transactions are transferred to the forfaiter.

Benefits to the Forfaiter:

1)  Eliminates Payment Risk:  In business, especially so in international trade, risk comes in many forms, and often small and minor mistakes can prove costly and result in loss either in monetary terms or in terms of prestige, reputation, etc.   And one of the most serious such risks is the risk of non-payment.

In forfaiting, the forfaiter is practically assured of payment, as the exporter’s Draft is pre-accepted by the importer, and further avalized by the importer’s Bank.   Even though payment defaults may still arise on account of insolvency, etc., the degree of safety enjoyed by the forfaiter does make life easier for him.

2)  Remunerative:  The forfaiter is entitled to various pecuniary benefits in forfaiting.   For example, a forfaiter charges interest for the period of credit he extends to the exporter.   Secondly, the forfaiter charges a fee for the various risks associated with the transaction.   Thirdly, the forfaiter charges a certain amount for expected delays in getting reimbursement from the importer.  This is specific to the country of the importer.

Benefits to the Importer(Buyer): 

1) Documentation:   The major advantage to the importer is the assurance that the documents from the exporter have been screened by a professional agency, thereby reducing the risk of misinterpretation, communication gaps, etc.

2) Credit Facility:  Another benefit for the importer is that, he is able to get the goods on credit which provides him space to arrange for payment from the proceeds of the consignment that he has imported, rather than pay upfront.

                                                                                                Concluded

Finance: Factoring-Part II

In an earlier article, we had studied the definition of Factoring.  In this article, we shall examine how a factoring transaction takes place practically.

Example:  M/s.Omega Foods is an upcoming  manufacturer of processed health foods for humans, based in Connecticut.   The Company’s products are gaining in popularity through the United States.   In the last year(2008), the Company had recorded sales of USD: 2.02 million.   The Omega range of health foods is widely available in the U.S., from the local Mom and Pop stores to some of the larger  Supermarkets.

M/s.Omega Foods distributes their merchandise in U.S.A. through a network of 65 distributors and dealers.   Further, they afford 35 days credit to them, on their bills drawn on these distributors and dealers, that is their buyers.

M/s.Omega Foods has an arrangement with Alpha Factors, a Company engaged in the business of Factoring, to avail of this facility to the extent of USD: 0.50 million at a time.   Under this arrangement, Alpha Factors advances money to Omega Foods, against their invoices drawn on their buyers.  

Let us assume that Omega Foods have made a sale of USD:0.25 million to M/s.Super Stores.   As per arrangement, Omega Foods notifies their buyer Super Stores of the factoring arrangement it has with Alpha Factors, and forwards a set of commercial documents including the invoice to Super Stores.   Simultaneously, it forwards another set of the documents to Alpha Factors.   Omega Foods have given 35 days credit to Super Stores to make good the payment for the merchandise supplied by them.

Alpha Factors scrutinize the documents submitted by Omega Foods, and finding them in order, remit USD:244,000.00 to Omega, as against the invoce value of USD:194,000.00.   Of the difference amount of USD:56,000.00, USD:50,000.00 represents the reserve amount retained by the Factor against possible payment default by the buyer,  USD:5,000.00 represents the discount at which the Factor has advanced money to the seller, and USD:1,000.00 represents the interest charged by the Factor for the 35 days that it will be out of funds, till the buyer reimburses it.

Let us assume that Super Stores have honored their committment under the factoring arrangement, and have remitted the amount of the invoice i.e. USD:250,000.00 to the Factor, within the stipulated time of 35 days.   Thereupon the Factor would release the reserve amount of USD:50,000.00 to the seller.   This would complete the transaction.

However, not all factoring transactions end happily.   Sometimes the debtor may default in paying the Factor and putting the Factor to financial risk/loss.   In the above example, let us assume that the buyer, Super Stores have defaulted and failed to pay the Factor in time.   The Factor, would, then have to either recover the money from Super Stores, or write it off eventually, as a bad debt.   The Factor does not have remedy against the seller, Omega Foods, unless the contract provides for a with recourse to seller provision.

In the with recourse to seller factoring contract, the Factor has the right to recover from the Seller, the amount defaulted in by the Buyer, that was advanced to the Seller (by the Factor).   In this example, if Super Stores were to default upon payment to the Factor, then Alpha Factors would have recourse to Omega Foods, and recover the same from them.   Usually this is done by submission of another invoice by the Seller to the Factor, who adjusts the outstanding from the earlier transaction, by advancing money against the new invoice.   Of course, the Seller has the choice to reimburse the Factor, with his own money.  

An important point to note in a with recourse to seller factoring transaction, the Factor would not get the same level of returns as in the without recourse factoring transaction, because of the elimination of risk in the latter case.   Another way out for the Factor is to obtain insurance against the Buyer’s default.

In future articles, we shall study the risks and prospects of factoring business to those involved in it.

                                                                                       To be concluded.

Financing: Factoring-Part I

Introduction:  One of the major stumbling blocks faced by a buiness is the financing of it.   A business requires money for various activities and purposes.   For example, a manufacturing concern requires money for procuring the raw materials, and processing the same into the finished goods.   That apart, money is required to pay the wages of the workforce,  servicing of the plant and machinery, upkeep of the premises, marketing of the products, etc.   Every stage of operations of the business requires infusion of money to ensure smooth functioning and to achieve the business goals.

Over a period of time, different methods of financing business have evloved.   The type of financing required by a business depends upon the nature of its activities, and related issues.   For example the type of financing required by a manufacturer of Televisions is different from that required by a Software Development Company.

Factoring:  Factoring is a type of financing available to any business that engages in sale of goods and services through the medium of the Invoice.   Practically, every business engaged in selling ‘raises’ an invoice on its buyer or client.   An invoice is a commercial document that provides details of the product or service being supplied, the unit price of each item of sale, the delivery terms, taxes where applicable, any discounts given, other charges if any, etc.   It also stipulates the time within which the buyer must pay for the goods and services.   This commercial document(invoice) represents the account receivables of the firm.   That is, the money that the firm will receive upon supply of the goods and services mentioned therein, from the buyer.

Now the seller of the goods and services as above, has two options to realize the proceeds of his sale.   One, he can wait for the buyer to make the payment in the normal course against the delivery of the goods/services as per the contract terms.   Second, the seller can also approach a ‘Factor’ to encash the invoice immediately.   The Factor is the financier who advances money to the seller against his invoices, that represent the seller’s receivables, at a discounted rate, and collects the full value of the invoice from the buyer. 

To clarify further, factoring is the financing of accounts receivables of the seller at a discount, and realizing the full proceeds form the buyer, now the debtor.   The factor first pays the seller, the realizable value of the goods and services evidenced in the invoice at a discount, and then recovers the full value of the invoice from the debtor, the buyer.

In a transaction like this, the factor, who is parting with his money, has to make sure of getting it back, not from the seller, but from the buyer.   Therefore, the financial standing and the creditworthiness of the debtor is of primary imoratance to the factor, more than that of the seller.   If the debtor defaults on payments, then the factor has  to suffer a loss.   As such, the factor would satisfy himself with the solvency of the debtor before engaging with him in this transaction.

There is another kind of factoring arrangement, called with recourse factoring.   It is similar to the regular or without recourse factoring, except that, in the event of default by the debtor, the factor has recourse to the seller, who has to make good the loss suffered by the factor.   That is the factor can recover the money advanced to the seller from the seller himself, alongwith his charges, etc., in case of the buyer’s default.

As can be seen, the with recourse factoring transaction is safer and more favorable to the factor.   However, for the same reason, that it is safer, it is also less remunerative to the factor.   The revenues and profits accruing to a factor are in proportion to the risk he undertakes under the transaction.

In future articles, we shall study how a factoring transaction actually looks like, the relative advantages and disadvantages of this type of financing for a business etc.

                                                                                          To Be Concluded

ISLAMIC BANKING SERVICES: IJARAH

Definition:  Ijarah is the equivalent of Leasing offered by Islamic Banks and Financial Institutions.   The activity of Leasing involves permitting the usage of a property, say a car, or a shop etc, owned by one person, by another, for a consideration, i.e. a monetary return.   While the ownership of the asset remains with the owner, or the lessor, the lessee, or the person that leases out the asset, will have the freedom to put such asset to beneficial use, in order to gain some benefit from the same.   There are two types of Ijarah-Ijarah Salam and Ijarah wa Iqtina.

Ijarah Salam:  Under this type of lease agreement, the lessee retains the possession of the asset for the duration of the productive life of such asset, which may be 10 years or 15 years as the case may be.  

 For example, a person takes a car on lease whose productive life is estimated to be, say 10 years.   The lessee would be entitled to the use of the car for 10 years by paying the lease rentals as agreed upon in advance,  for the fixed amount within the stipulated date without default.   The car will remain in the possession of the lessee for the duration of its productive life cycle, in this case, 10 years, after which the lessee will return the asset to the owner, who by the way, continues to retain the ownership of the car during the lease period.   This type of lease contract is convinient to both the lessor and the lessee and fulfils their respective requirements.  

Ijarah wa Iqtina:  Under this type of lease contract, the lessee has the option, though not the compulsion, to buy the asset leased out from the lessor upon completion of the lease period.   The rate at which the asset would be purchased by the lessee would be mutually decided upon by both the parties to the lease contract.   As in the first type of lease contract, the ownership of the asset vests in the lessor and the lessee would only have the right to put the asset to beneficial use.   And the lessee would be obliged to pay the lease rentals at the rate agreed upon at the stipulated intervals without default.   At the end of the lease period, the lessee would have the option of buying the asset off the lessor and become the owner of the same.   The rate at which the asset would be sold to the lessee would depend upon the quality of the asset, the remaining life cycle of the asset, the market conditions, the demand and supply position etc.

Beneficial Arrangement:  Ijarah and Ijarah wa Iqtina contracts are  beneficial to both the lessor and the lessee.   The lessor, who owns the asset,  may not have the time and the inclination to put his asset to beneficial use and may only be incurring expenditure in maintaining the same.     This arrangement provides an ideal way for him to put his asset to good use and derive some financial benefit from it.   In the same way, the lessee may have the necessary skills to utilize the asset and derive financial benefit from the same, but may not have the capital to purchase the asset.   This lease arrangement, thus provides him the medium to possess the asset without owning it and to apply his knowledge and skills to put the asset to beneficial use.   What’s more , he has the option to buy the asset from the owner, in future, if that suits his needs.   Hence it is a mutually beneficial arrangement.

As in other types of financing under the Islamic system, the Ijarah contract also relies to a great extent upon the integrity and honesty of the parties to the contract.   Some of the most important responsibilities of the parties to the Ijarah contract are:   the lessor should not only be the owner of the asset, but must have possession of the same.   Ownership without possession, or vice versa does not fulfil the requirements of this kind of contract.   In the same way, the lessee is expected to take good care of the asset, as he would if it belonged to him, even though he not the owner of the asset.

Note:  Readers please note that this article is not an exhaustive study of the Ijarah contract, but only meant to give a basic understanding of the same.