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What is trade finance?
Trade finance provides credit for international trade flows. It exists to reduce the risks of international trade transactions, and to help with business cash flow.
International trade transactions ultimately involve two parties — importers and exporters. Importers seek to pay only for the correct type of goods — at the right quantity and with the right quality. Exporters require payment for their goods or services — before shipment is made. Trade finance sits in the middle of the two — acting on behalf of both importer and exporter.
These importers and exporters may be producers, manufacturers and/or traders.
In contrast with trade finance, purchase order finance — is focused on domestic trade and business.
Trade finance — considerations
Businesses often need to trade internationally — trade finance is an umbrella term for all the different products and instruments that allow companies to do so. Trade finance enables companies to take part in international business, by making the sale and movement of goods around the world — much easier.
Trade finance works for both importers and exporters. You could be a small business wanting to import you first batch of goods, or you could be looking to grow your business by exporting overseas. As an importer you don’t want your money tied up in the shipment of goods, while as an exporter you can’t afford to wait until goods are delivered — before being paid.
Trade financing differs from normal credit issuance. While general credit is sought when companies need extra cash — trade finance does not necessarily mean a buyer lacks funds. Trade finance is just as much about money — as it is about the risks that international trade comes with. These risks include non-payment, currency fluctuations, political instability and more.
Parties involved in trade financing deals include banks, trade finance houses, importers, exporters, insurance companies, export credit agencies, government entities and more. Each of these parties has its own particular role to play in any trade finance deal. Activities they are involved in include — issuing letters of credit, lending and forfaiting.
Most banks will not provide general loans for worldwide trade. Additionally, other forms of finance like credit cards are not really suitable. As such, trade finance is essential for businesses that trade globally, or will likely do so in the near-future. Further, having the right trade financing partner — will allow you to negotiate the best terms possible with suppliers.
How does trade finance work?
For importers, banks or trade finance houses may require a purchase order or a robust sales forecast — for any goods you wish to import. If you don’t already have an on-going relationship with the bank or trade financer, further information will be required — such as business trading history and your financial statements. Should you be approved for financing, the bank can issue a letter of credit to the exporter — promising to pay them as soon as your order has been dispatched.
For exporters, you can receive credit or funding against invoices raised — on overseas customers. You’ll subsequently have a certain number of days to make repayment. This credit frees up your working capital — for other uses.
In both cases, the credit provided and other services offered (bad debt protection, foreign exchange etc.) — may be subject to fees and interest. This would be outlined in the finance contract you have with the bank or lender. Other terms and conditions, such as credit term length and limits — will also be highlighted.
Types of trade finance
A bank can guarantee that either the importer or the exporter — will fulfill the terms of a contract. Banks would compensate the beneficiary — should either party not meet its obligations.
A documentary collection is a transaction where a bank collects payment on behalf of the seller — by giving the relevant documents to the buyer.
A bank acting on behalf of an importer, can issue a letter of credit to an exporter — promising to make payment as soon as a transaction is completed.
Import finance involves a range of funding solutions, that provide money for the purchase of goods — from one country to another.
Export finance refers to a set of specialist financing solutions — focused on helping companies export products and services.
Supply chain financing allows buyers to extend payment terms, and suppliers to get paid earlier.
Businesses are paid based on a percentage of their accounts receivable (invoices).
Exporters get cash straightaway, by selling longer-term receivables (money importers owe to an exporter) to a forfeiter — at a discount.
Helps both exporters and importers with short-term cash requirements.
Used to protect the shipment and delivery of goods — as well as providing protection against non-payment.
Benefits of trade finance
- Offers guarantees — for payment and supply
- Frees up cash — that can be used in other aspects of your business
- Sell invoices to lenders — who then directly collect payments from customers
- Can be used alongside other financing solutions
- Lenders may pay VAT and import duty for you — upfront
- Some lenders offer foreign exchange solutions
Limitations of trade finance
- It can be expensive — compared to other financing solutions
- 100% financing is not guaranteed
- May not get funding for smaller orders
- Not flexible — funds can only be used for specific purposes
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