In today’s article I’m going to talk about trade finance and how it can help your business. I’ll be covering everything from use cases to different types of trade finance.
What is trade finance?
Trade finance is the name given to a number of short-term business finance instruments used by companies that trade in physical goods.
Trade finance can be used for either domestic or international trade where one party offers credit to the other.
It is most commonly used in international trade, because of the large number of risks involved in transacting with an overseas trading partner.
Trade finance instruments and practices include:
Short Term Loan
Letters of credit
Bills of exchange
Trade credit insurance
Why do businesses use trade finance?
Trade finance can be expensive, but it is popular with business owners because it mitigates some of the common risks and disadvantages of trading on credit, including:
The buyer could pay for the goods, but the seller not ship them
The seller could ship the goods, but the buyer not pay for them
The buyer could delay payment beyond the agreed credit terms
Currencies could move between purchase and payment, making the transaction more expensive or less profitable for one of the parties
The transaction could be interrupted by factors beyond the control of either party, such as political instability
While the first three risks are relevant to domestic trade too, the level of risk is greater with international trade because it can be much more difficult and expensive to take cross-border legal action and recover losses.
Legal systems and trade customs vary from country to country and you may not have the same protections as you would in a domestic transaction.
The other main reason that both domestic and international traders use trade finance is cash flow.
You may have substantial up-front costs of manufacturing, storing and shipping goods, and a lengthy delay before you receive payment.
It’s common for businesses in many sectors to offer credit terms of between 30 and 90 days – and even if your trading terms are cash on receipt, overseas shipping can be a slow business.
In the meantime, there are fixed costs, wages, tax bills, insurances and the cost of more materials for your next sales to cover.
Cash-flow problems are the number one reason Australian businesses – of any size – fail, so financing shortfalls in working capital can be crucial to survival, especially if your customers are slow to settle their invoices.
Who is involved in trade finance?
Trade finance always involves at least three parties:
In some cases, an insurance company will also be involved.
Types of trade finance
Short Term Loans
These are like any other form of unsecured short-term business loan and are generally arranged by the seller to help cover the up-front costs of sale, or to smooth over cash flow issues caused by the gap between sale and payment.
If you successfully apply for a business loan, your finance provider will advance funds to your business for an agreed period at an agreed rate of interest.
Why did I say finance provider instead of a bank? Because you’re unlikely to qualify for a short-term business loan from a bank unless yours is a very well-established business with an excellent credit rating and collateral to offer.
However, there are many alternative finance providers to choose from, some of whom offer unsecured business loans even to businesses with poor credit ratings. Many will allow you to choose a loan term and repayment schedule that suits the specific needs of your business.
But be sure to shop around, as terms and conditions, as well as costs, can vary widely – and there can often be hidden fees and charges in addition to the advertised interest or factor rate.
Applying for an unsecured business loan is usually a swift and straightforward process, which can often be completed online within a matter of days or even hours.
If you’re applying for a loan on the basis of a specific export contract, expect to be asked for a copy your contract as part of the supporting documents for your loan application, (along with six or more months’ bank statements and trading records).
Letters of credit
A letter of credit is arranged by the buyer rather than the seller.
As an exporter, it allows you to send goods without receiving payment in advance, but knowing that you will receive payment as soon as you prove you have met the conditions set out in your contract.
Generally, you will have to show the buyer’s bank evidence (such as a bill of lading) that you have shipped the goods within the agreed timeframe.
The main advantage of a letter of credit is that it takes away the credit risk involved in cross-border trading with unknown business partners. Instead of risking that the buyer won’t be willing, or able, to pay for the goods on receipt, you have the confidence of dealing with a reputable financial institution.
Depending on the terms and conditions of their finance provider, your buyer may:
Buy the letter of credit in advance, paying the purchase amount of the goods plus an additional fee for the service.
Repay the financial institution later, delaying payment for the goods until they have been received, or on other agreed terms. This transfers the credit risk from you to the finance provider, so the buyer will generally need to provide security and pay a higher fee to compensate for the risk. That security could be the goods being shipped, or other assets. Because of the level of risk, many lenders will only provide this service to businesses that have a strong trading history and a good credit rating.
Letters of credit are one of the most common forms of trade finance instrument and play a very important part in international trade, by ensuring that transactions go as planned:
- Once the you meet the criteria set out in the sale contract you are guaranteed to receive payment.
- The buyer doesn’t risk handing over funds until their financial institution has proof that you have met the contract criteria.
Guarantees are very similar to letters of credit, in that a trusted third-party, the bank or financial institution, guarantees that the buyer or the seller will receive what is due to them under the contract.
The main differences between a guarantee and a letter of credit are that:
- A guarantee can be used to protect either party in the transaction, not just the seller. In many cases, both parties have to provide a guarantee.
- Under a guarantee, the finance provider will only make a payment if the transaction goes wrong – i.e. if the seller fails to provide the goods which the buyer has paid for, or if the buyer fails to pay for goods that have been provided.
While letters of credit are most commonly used in international trade, bank guarantees are often used in high-value transactions, both domestic and international – such as property or infrastructure deals. Your bank may provide a guarantee up to an agreed limit rather than for a specific amount.
By providing a guarantee, your bank or financial institution becomes contractually obliged to recompense the other party if you fail to fulfil your obligations.
For this reason, banks tend to screen prospective clients very carefully, and you may find that you can only get a bank guarantee if you have a well-established business with a strong, profitable trading history.
Documentary collection is an arrangement usually used by established international trade partners who have built up a level of trust.
It will not offer you the same level of protection as a letter of credit, because the buyer’s bank does not guarantee that you will receive payment. However, it enables you to retain control of the goods you have shipped until you receive payment.
Once you have shipped the goods your bank will present documents to the buyer’s bank proving that you have fulfilled your obligations under the contract.
The buyer’s bank will then contact the buyer to let them know that they have proof of shipping, and request payment. Once the payment has been made your bank will release the documents to the seller’s bank, and the buyer will then be able to take possession of the goods.
Depending on your agreement with the buyer, you may receive a cash payment in exchange for the documents, or a draft (also known as a ‘bill of exchange’ or ‘promissory note’) in under which the buyer is obliged to pay after 30, 60 or 90 days.
The main difference between documentary collection and a letter of credit is that the buyer has the option to refuse the shipment and decline to pay. This can leave you with the cost and hassle of recovering and transporting the goods back – but at least prevents the risk that your buyer takes possession and then refuses to pay.
Because of the lower level of risk to the bank, documentary collection is usually quicker, cheaper, and more easily available than a letter of credit.
Bill of exchange
A bill of exchange or ‘draft’ is like an endorsed cheque. It is a legal obligation for one party to pay another an agreed amount, at an agreed date in the future.
If the draft is drawn on a reputable bank it eliminates credit risk, by guaranteeing that you will receive the payment due to you when the draft falls due. In many cases you will have the option to sell a bill of exchange to a third party at a discounted rate – giving you up-front access to cash instead of having to wait for the payment date.
Bills of exchange can change hands multiple times, with the buyer (or their bank) having to pay the final owner of the bill when the payment falls due.
Trade credit insurance
Trade credit insurance is a policy that protects you against the risk that your customers don’t pay their invoices. When you take out a trade credit insurance policy you pay a premium to a third party (an insurance company or export credit agency) and they agree to reimburse you if a customer defaults on their payment.
Trade credit insurance has two major advantages:
- Like any other insurance policy it provides you with protection against financial loss if something goes wrong, which is especially valuable if you are trading overseas or dealing with new customers and are unsure of their creditworthiness.
- It transforms your accounts receivable from an unsecured into a secured asset – which you can then use as collateral for a business loan. This is why trade credit insurance is considered a trade finance instrument rather than just an insurance policy.
Factoring, also known as ‘forfaiting’ or ‘invoice finance’, is a common form of business finance used by businesses in many sectors, not just international traders.
It is not debt finance: rather than borrowing from a lender, you sell the amounts due to you from your customers to a third party.
The way factoring works is that your finance company will advance you a percentage of the invoice amount – usually between 70% and 90% – and then collect payment from your customer when the invoice falls due. At that point they will deduct a percentage for their fee, then transfer the balance to you.
The key advantages of factoring are that:
- You get cash up front, allowing you to offer credit terms to your customers whilst bridging the gap between sale and payment.
- You don’t have to worry about chasing customers for payment. However, there are two types of factoring:
- Recourse, which means that if your customer fails to pay you will have to repay the advance to the finance company and collect the debt yourself.
- Non-recourse, which means that if the customer defaults you lose the balance payment but do not have to repay the advance, and the responsibility for collecting the debt remains with the finance company.
- Factoring depends more on the creditworthiness of your customers than on the standing of your business, so it may be available even if you have not been tsrading for long or have a poor credit score.
While factoring can be extremely convenient, it also has several drawbacks:
- It is generally more expensive than other forms of business finance such as an unsecured business loan.
- Unless you are willing to pay more for flexibility, you may be locked into a contract where you have to sell all your invoices for an agreed period of time (or all invoices for specific customers), even if you do not need the cash.
- It’s a very public arrangement – since the factoring company will deal directly with your customers, those customers will see that you are relying on factor finance and may be concerned about your solvency.
- You have no control over the way the factoring company communicates with your customers – if they use aggressive collection methods they could do lasting harm to your business relationships and reputation.
Trade finance helps you do business with other companies, especially when you want to do business with an international company.
There are many use cases, such as dealing with exporters, importers, traders, manufacturers, producers.
Understanding all the different types of trade finance above will help you decide which trade finance option is best suited for your business.
Are you looking to grow your business by working with international businesses? Or is it that you’re planning to trade fiance for domestic purposes? Leave a comment below.