Essentially, trade finance is a catch-up term for making import and export transactions in international trade.
In other words, it’s when an exporter requires an importer to prepay the goods shipped.
As an owner of a business (especially SMEs), naturally, you would want to reduce risks to the greatest extent, and you definitely do not want your cash flow to get tied up in shipments for weeks to wait for the overseas manufacturer to arrive.
Besides SME owners, here are the other common users of trade finance:
Now, that’s when trade finance steps in and helps you reduce costs and streamline the flow of your trade logistics.
How does Trade Finance work?
To put it simply, the importer’s bank will provide a letter of credit to the exporter.
This is to provide payment with the presentation of certain documents, such as the bill of lading. Judging by the basis of the export contract, the loan may be made by the exporter bank.
There are 2 criteria that determine what kind of documents you use:
- Nature of the transaction;
- How evidence of the performance can be shown (e.g. bill of lading to show shipment)
Now, there’s one thing you should take note of: the bank will only deal with the documents, any concern relating to the product, services, or performance-related will not be under their concern.
Want to know more about trade finance in detail? Click here to check out our article What is trade finance and how does it work?
Why do your SMEs need Trade Finance?
No matter what size your business be: you could be a small business importing products/materials from overseas, or multinational corporations doing imports or exports of a huge stock of inventory around the globe annually.
You want your get your money in and out of the tunnel as soon as possible, and not having worried about how complications like the volatile exchange rates or cash flow problems risking your trading process.
What you want here is to have your risks handled properly and make sure your flow of transactions is smooth and free of any cash flow imbalance issues that’ll possibly add up to the costs.
1. Letter of Credit
To put it simply, a letter of credit is a pledge for making payment issued by a bank on behalf of the importing client. It’s a common trade finance document that you must know about.
Essentially it is an undertaking by the bank to pay the exporter the money in a certain time period upon the negotiated terms and conditions.
It allows sellers and buyers to mitigate part of the inherent risks in international trade, including currency value fluctuation, non-payment, and economic instability.
How it works:
Usually, when the importer (aka the buyer) wants to purchase products from an exporter (seller), the buyer will reach to the seller’s bank along with a purchase order.
Depending on their level of credibility, a letter of credit would be issued by the bank.
Then, it will be followed by the exporter’s bank request of LC from the buyer’s issuing bank.
As soon as they receive the letter and verify the terms, the exporter will clear the bank and the goods will be ready to be shipped.
After that, the seller’s bank will issue the payment to the seller.
Then, the buyer’s bank will receive the forwarded shipping papers and the importer will request the payment.
Types of Letter of Credit (LC):
There are different types of letter of credit available at the moment, but it depends on whether it’s for business or personal requirements. Here are the common types of letter of credit (LC):
- Commercial Letter of Credit: this is usually referred to as the import/export credit. A confirming bank from the exporter’s side will release funds upon agreed conditions.
- Standby Letter of Credit: It’s designed for payment/compensation guarantee in case certain terms or conditions fail to meet.
- Transferable Letter of Credit: It allows the beneficiary to transfer either part or all the payment to another supplier.
- Back-to-Back Letters of Credit: it connects importer and exporter by allowing intermediaries.
- Revolving Letters of Credit: It allows businesses to do multiple different transactions on solely one LC until it expires.
2. Purchase Order (PO) Finance
Purchase order (PO) finance is designed for SMEs who face inefficacy of cash flow problems.
This is part of the pre-shipment solutions for trade finance. Essentially, it provides capital to pay suppliers with the verified purchase order to guarantee smooth cash flow.
It enables businesses to accept a large volume of orders and adjust the loan basis to meet their needs.
It’s especially true for SMEs as most of the time you receive a large volume of orders but don’t have enough working capital to process it. It solves exactly that problem.
PO finance advances to a certain percentage by the financial institution, usually 30-70% of the purchase order amount. Even if the volume of orders decreases, there are no tied arrangements, which means you can stop using it anytime you want.
How it works:
As soon as the end customer received the purchase order (PO), the supplier will be paid directly by the financier.
Then the financier can receive payments from the buyer/customer. Usually, the customer will be paid 60-90 days after the shipment arrived.
But then there’s a thing you should take note of: in between the payment and shipment period, it creates a capital gap.
The problem with that is you could risk losing the order if you have no money in between to support it.
To solve the capital problem, businesses would usually go for traditional financing. But then the problem with it is that not all bank requirements can be satisfied.
Qualifications for PO finance:
If your business is considering PO finance for more flexible cash flow, here are a few of the simple requirements you should pay attention to:
- Sell to B2B & B2C customers
- An order of >$20,000
- Sell finished products (raw materials or product parts is not accepted)
- Profit margins of 15-20%
- Creditworthy customers
- Reputable suppliers (manufacture & deliver products to customers on time)
3. Supply Chain Finance
Supply chain finance (SCF) is actually for sellers, buyers as well as financial institutions. The main goal of it is to better the payment terms and make your cash flow more flexible in the supply chain process.
The buyer would negotiate payment terms, including an extended payment schedule.
At the same time, the seller can also get immediate payment while unloading the products quickly.
Now, we should clarify this one thing first: supply chain finance is not a loan per se. In fact, it is a technology-based cash flow solution that lowers financial costs. It mainly does these things:
- Automate transactions;
- Track invoice approvals & settlement processes;
Now, the good thing about it is that it frees up some of your working capital while you wait for the shipment to arrive. So your money wouldn’t get trapped in the supply chain and make your cash flow more flexible.
How it works:
Essentially how it works is that buyers will need to approve their suppliers' invoices for financing. This can either be done by a bank or other third-party financier (aka "factors").
And it provides liquidity for both the buyer and the seller through providing short-term credit. This can optimize the working capital and make the cash flow more flexible for both of the parties.
If you’re a supplier...
- Instead of having to wait for the 30-day credit terms, the suppliers can be paid earlier;
- Insurance provided to reduce financial risks;
- Provides liquidity
If you’re a buyer...
- Enables buyers the ability to purchase in bulks to save costs;
- Can work with complex end-to-end supplier chain;
- Maintains a healthy balance sheet
How can Trade Finance Benefit My Business?
To purchase goods or stocks, the first step for you is to secure the funds necessary for the growth of your business.
And the best way to do it is by using a tool that helps you manage the cash flow and working capital.
The good thing about trade finance is that it can unlock capital from your business’s existing stock or receivables based on the trade cycles in your company.
The key point is to reduce your payment gaps.
It can enable you to offer more competitive terms for both your suppliers and customers to increase your competitive edge and reduce other risks such as payment, country or corporate risks included.
By reducing these payment gaps, exchange rate risks could be significantly minimized, and thus, the efficiency and flow of your trading cycle can be maximized.
Invoice discounting isn't technically a trade-financing specific activity, but some trade financing institutions are also operating with this product as well.
Want to have your international payments are taken care of and risks managed at the same time? Click here to check out our affordable solutions for your business.
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