Why Companies Need Trade Finance?
Both buyers and sellers can benefit from trade finance.
For buyers, an investment in goods can make a significant dent in working capital. This can be a considerable problem for importers purchasing goods from overseas. Being able to access trade finance allows importers to fund the purchase of goods and generate revenue without suffering cash flow gaps while waiting for goods to arrive.
For suppliers, working with a large client or offering extended payment terms can result in a shortage of working capital. Trade finance enables companies to release the capital tied up in the manufacturing and shipment of goods.
A lack of cash flow is not the only reason companies need trade finance. Many large businesses with sufficient liquidity seek trade finance to mitigate the risk involved with international and domestic commerce.
How Trade Finance Can Reduce Risk
Trade finance helps to mitigate risk by accommodating the conflicting needs of the buyer and seller.
The seller would prefer to receive payment upfront to avoid the risk that a buyer will be unable to pay for goods once they have been shipped.
The buyer would prefer extended payment terms to ensure the goods are shipped and to avoid the risk of paying for goods that are not received.
A trade finance solution can be used to reduce the risk for both parties. For example, a letter of credit can be used to ensure that payment is only released once the supplier has presented the bill of lading to the financier. The letter of credit offers the seller a guarantee that the goods will be paid for once they are shipped.
Trade finance covers a range of financial solutions that can be tailored to the needs of importers and exporters. Multiple financial products can be used together to facilitate trade and ensure a smooth transaction.
The Benefits of Trade Finance
Aside from risk mitigation, trade finance offers many benefits for businesses looking to purchase and sell goods in the UK and around the world.
A funding facility helps to increase liquidity and avoid any cash flow gaps. You can pay your overheads and be confident that you have the financial backing to take on new orders. You may be able to offer extended payment terms to your customers, or secure bulk buying/early payment discounts from your suppliers to increase your margins.
Trade finance empowers SMEs with the capital they need to increase the turnover of goods, secure deals with larger customers, and scale revenues to increase profitability.
Why not just use Telegraphic Transfer and Open Accounts?
Telegraphic transfer is a simple, fast and straightforward way of moving funds between buyers and sellers. It’s essentially an electronic way of paying cleared funds to a designated bank account.
While it remains one of the most common and practical methods of payment in trade finance transactions, used in isolation it has one significant shortcoming – it imposes significant risk on the buyer.
Without any means of quality assurance or of even obtaining a guarantee of delivery, the buyer is exposed to the possibility of not getting the service or merchandise they paid for. Put simply, a telegraphic transaction pushes all risk onto the buyer.
An alternate mechanism is for the exporter to use an open account. In this arrangement, the exporter extends an open line of credit to international customers, with a request to be paid on delivery.
Obviously, this is a great arrangement for the buyer. The exporter, however, is accepting considerable risk. Not only is the exporter dependent on the good faith of their customer, they’re also vulnerable to unforeseen circumstances in the shipping process, unfavourable exchange rate variation and the list goes on.
Both illustrate an important basic principle for trade finance: the importance of mitigating risk.
What is a Letter of Credit?
A letter of credit is a trade financing mechanism designed to allow both buyers and sellers to mitigate some of the inherent risks in international trade, such as non-payment, currency value fluctuation and political or economic instability.
In somewhat simplified terms, here’s how it works.
When a buyer (the importer) wishes to purchase goods from an exporter, they’ll approach their bank with a purchase order. Provided they’re creditworthy, the bank will then issue a letter of credit.
The exporter’s bank will then request the letter of credit from the buyer’s issuing bank. Once the letter is received and its terms verified, the exporter’s bank will clear the exporter to ship the goods.
On receiving the shipping papers, the exporter’s bank will issue payment to the exporter. The shipping papers will then be forwarded to the importer’s bank and payment will be requested from the importer.
By acting as a go-between for the buyer and the seller, a letter of credit greatly reduces both parties’ risk. It’s a critical tool in much of the international trade taking place in the world today.
However, letters of credit only solve part of the problem. They also create their own problems.
While this trade finance instrument reduces risk, it doesn’t eliminate it entirely. Letters of credit are typically filled with complicated and detailed provisions. Any discrepancy or oversight in these terms may nullify one of the party’s payment obligations.
They can also involve slow approval times (months in some instances), which hamstrings importers and exporters alike in responding to market demand.
Perhaps most critically, importers can only use a letter of credit if they’re deemed creditworthy and the line of credit will have a direct impact on the importer’s banking operations.
Are there any Enhanced Import and Export Financing Solutions?
The letter of credit is a powerful trade finance tool, but on its own it’s insufficient to meet the demands of international business.
More sophisticated and all-encompassing trade finance tools are available. These are designed to allow businesses faster access to finance, greater adaptability to market changes and improved cash flow throughout the entire cycle of order through to shipping and delivery.
What is Import Finance?
The goal of import finance is to improve the purchasing power of importers by giving them the option to defer part or all of their purchasing costs until they realise a profit from sales.
Import finance is frequently combined with a letter of credit arrangement to simultaneously offer the importer both greater flexibility and protection against risk factors.
In simple terms, here’s how import finance works.
The buyer will apply for an import finance transaction with a finance institution. Once approved, a letter of credit or telegraphic transfer will be initiated and the seller will produce and ship the ordered goods.
The seller will be paid by the buyer’s bank and an import bill will be created.
Once the goods are cleared and reach the buyer, the import bill will be repaid from debtor finance proceeds. The buyer can then clear the debtor finance on agreed terms.
The benefits here are twofold.
The lengthy period between ordering goods and receiving payment is avoided, assisting both the importer and the exporter in doing business. The buyer will also benefit from quicker growth and stronger sales due to the increased purchasing power import finance can offer.
The cost of this kind of service varies between finance institutions, as do the terms of repayment.
What is Export Finance?
Less than 10% of UK businesses are currently involved in export.
Long payment terms can further exacerbate their working capital challenges. Long delays for cross-border transactions are now commonplace.
Using export finance, sellers can receive funding against invoices raised on overseas customers. There are two major benefits here for the exporter. This removes the barrier of tied-up working capital and alleviates transitional financial pressures.
It also means the exporter can trade on open account terms (usually utilising export credit insurance for added security), thus reducing a critical barrier to international sales.
Export finance is often offered as part of a comprehensive package of services, known as export factoring. With this package of services, rapidly available export finance is provided against invoices.
The CBI here in the UK are calling out for change, with their slogan “Make The UK An Exporting Superpower” You can learn more about it
here.
While the world is becoming increasingly interconnected, small and medium sized enterprises in the UK face unique challenges in accessing international markets.
Trade finance is a crucial tool in paving the way for international business. Not only does it open the opportunity for risk mitigation, it offers importers a solution to cash flow challenges and exporters the required capital to fund their expansion.
