This is the sale of a company’s short-term accounts receivable to a foreign company for cash at a discount. The company in turn assumes the credit risk of the foreign buyers and is responsible for the collection of arrears.
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Advantages to the exporter
- The exporting company receives cash immediately upon the delivery of goods hence increasing their cash flow.
- Factoring protects the exporter from bad debts arising from foreign customers.
- The risk of the exporter’s credit is transferred to the factoring company hence the exporter is protected against credit losses.
- The factoring company also offers advice on international trade matters such as documentation and shipping regularities.
- The exporter is relieved of the task of collecting debts from foreign customers at maturity.
- The factoring company is better placed to collect debts from foreign customers than the corporation being factored.
Disadvantages to the exporter
- Export factoring comes at a cost since the exporter does not receive the full amounts of the debt. Factoring comes at a premium to the factoring company.
- Minimum factor level volumes set up by factoring companies may lock out an exporter from acquiring factoring services.
- There is a loss of personal touch between foreign customers and the exporter since the exporter cedes control to the factoring company.
- Factoring companies have many guidelines that have to be met by the exporting company such as guaranteed product quality and performance levels.
- The responsibility to ensure that debt instruments are validly prepared rests with the exporter.
Other methods of international finance for exporters
Bill of exchange
A bill of exchange is a written agreement between an exporter and importer demanding payment of a certain amount at a specified future date. Upon maturity of the bill, the importer pays the amount to the exporter’s bank, which in turn transfers the money to the exporter. The exporter is therefore protected from customer defaults.
Letters of credit
This is a financial instrument, which promises to make payment to the exporter at a certain specified future date. The importer’s bank makes the promise to advance the amount upon receiving instruction from the foreign buyer.
In the case of documentary collections, the exporter entrusts the collection of foreign debt to its bank, which sends the payment documentation to the importer’s bank. Funds are therefore received by the importer’s bank and then transferred to the exporter’s bank, which finally provides payment to the exporter. The title of the goods is transferred to the importer upon payment.
This is the most advantageous method to an exporter. Payment for goods is made by the importer before the goods are delivered. The exporter is, therefore, free from credit risk and other liabilities that may arise from foreign receivables.
Financing methods available to an importer
This is the most advantageous financing technique to the importer. The goods are shipped and delivered to the importer before compensation is payable. The importer is usually allowed a 30 to 90 days grace period to advance the payment after receipt of the goods.
Letter of credit
This is a financial instrument drafted by the importer’s bank, promising to advance payment to the exporter on a specified date upon instructions by the buyer. The importer’s bank facilitates international finance by acting as an intermediary between the importer and the exporter (Hull,56).
This is an international financing technique whereby the importer makes payment to the exporter after the importer has sold the goods to the end-users and has received payment. This is a risky term for the exporter since payment is contingent upon sales to the end-user by the importer.
In this method, the importer uses available inventory as security to acquire loans for financing imports. The importer can therefore effectively increase inventory without affecting cash flows. Inventory-based financing is an asset-based line of credit for the importer.
Import finance considerations
Before choosing a method to finance imports, the importer has to make the following considerations:
- The cash flow availability and needs of the importer.
- Urgency, the importer must consider time constraints to choose a method that is not inconvenient.
- The importer must consider the relationship with the supplier, which will influence willingness to accept terms and conditions.
- The nature of the product being imported.
- Interest and currency rates to avoid risk exposure caused by fluctuations.
- The current economic conditions.
With respect to international finance, the term counter trade refers to the exchange of goods and services for other goods and services instead of money. Money is only used for the valuation of goods and services for accounting purposes. Countertrade between countries is normally preceded by a bilateral agreement (Fabozi,8).
Examples of countertrade transactions
- Barter Trade: direct exchange for goods or services for other goods or services between two countries. For example, a country may supply oil products to another country in exchange for electronic equipment. No cash is involved in the transaction.
- Counter purchasing: A company may supply goods to a foreign country under an agreement that the foreign company will procure goods from the supply company at some expected future date.
- Payback: this is whereby a company invests in a foreign country with a promise to receive a certain percentage of the profits. For example, a company may construct a factory in another country and in turn, receive a certain portion of the revenues generated from the factory.
Fabozi, Frank. The Handbook of Financial Instruments. New York: Wiley Fiinance, 2002.
Hull, John. Options, Futures and Other Derivatives. London: Prentice Hall, 2008.
Levi, Maurice. International Finance. 5th. New York: Routledge, 2009.
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Mishkin, Fredrick. The Economics of Money Banking and The Financial Markets. London: Pearson Education, 2006.