Trade Finance Explained: 5 Facts You Need to Know
Here's a look into trade financing and what it can offer your business
Trade finance makes import and export transactions possible for entities, ranging from a small business importing its first private-label product from overseas, to multi-national corporations importing or exporting large amounts of inventory around the globe each year.
Smaller businesses often have very limited access to loans and other forms of interim financing to cover the cost of goods they plan to buy or sell. Even with a confirmed order for products, many banks won't provide loans or overdraft protection for these types of transactions.
Business owners, both small and large, don't want to have their own money tied up in shipments of goods that could, for example, take four to six weeks or more to arrive from an overseas manufacturer.
On the flip side, companies that export large amounts of goods can't necessarily afford to wait until their export products have arrived at some distant destination weeks later, before receiving payment. Some sources estimate that over 80 percent of global trade depends on trade financing, which helps goods keep moving even when companies don't have enough cash flow internally to finance the transactions themselves.
How the Process Works
Trading intermediaries such as banks and other financial institutions oversee and facilitate different financial transactions between a buyer (importer) and a seller (exporter). These financial institutions step in to finance the business transactions between the buyer and seller. These transactions can take place domestically or internationally. The availability of trade financing has spawned huge growth in international trade.
Trade finance covers different types of activities such as issuing letters of credit, lending, forfaiting, export credit and financing, and factoring. The trade financing process involves several different parties, including the buyer and seller, the trade financier, export credit agencies, and insurers.
1. Trade Finance Reduces Payment Risk
During the early days of international trade, many exporters were never sure whether, or when, the importer would pay them for their goods. Over time, exporters tried to find ways to reduce the non-payment risk from importers. On the other hand, the importers were also worried about making prior payments for goods from an exporter since they had no guarantee whether the seller would actually ship the goods.
Trade finance has evolved to address all of these risks by accelerating payments to exporters, and assuring importers that all the goods ordered have been shipped. The importer's bank works to provide the exporter with a letter of credit to the exporter's bank as payment once shipment documents are presented.
Alternatively, the exporter's bank may give a business loan to the exporter while still processing the payment made by the importer as a way to keep the supply of goods active instead of keeping the exporter waiting for the importer's payment. The loan extended to the exporter will be recovered by the trade financier when the importer's payment is received by the exporter's bank.
2. Reducing Pressure on Both Importers and Exporters
Trade finance has led to enormous growth of economies across the globe because it has bridged the financial gap between importers and exporters. An exporter is no longer afraid of an importer's default in payments, and an importer is sure that all the goods ordered have been sent by the exporter as verified by the trade financier.
3. Various Trade Finance Products and Services
Trade financiers such as banks and other financial institutions offer different products and services to fit the needs of various types of companies and transactions:
- Letter of Credit: This is a promise undertaken by the importer's bank to the exporter, saying that once the exporter presents all the shipping documents as spelled out by the importer's purchase agreement, the bank will immediately make the payment to the exporter/seller.
- Bank Guarantee: A bank acts as a guarantor in case the importer or exporter fails to fulfill the terms and conditions of the contract. The bank takes an initiative to pay a sum of money to the beneficiary.
These two products have many different variations to accommodate different types of transactions and circumstances.
4. Factoring in Trade Finance
This is a very common method used by exporters as a way to accelerate their cash flow. In this type of agreement, the exporter sells all of his open invoices to a trade financier ( the factor) at a discount. The factor then waits until the payment is made by the importer. This relieves the exporter from the risk of bad debts and provides working capital for them to keep trading. The factor, or trade financier, then make a profit when the importer pays the full agreed-upon price for the goods since the exporter sold the account receivables at a discount to the factoring company.
This is a form of agreement whereby the exporter sells all of his accounts receivable to a forfaiter at a certain discount in exchange for cash. By so doing, the exporter transfers the debt he owes to the importer to the forfaiter. The receivables bought by the forfaiter must be guaranteed by the importer's bank. This is due to the fact that the importer takes the goods on credit, and sells them before paying any money to the forfaiter.