1. Letter of Credit (LC) - A contractual commitment made in trading by exporters and importers.
2. Purchase Order (PO) Finance - A method used to cover procurement costs from suppliers issued by the buyers.
3. Supply Chain Finance - A financing solution that provides suppliers with advanced payment to avoid supply chain disruption.
Why do SMEs need trade finance products?
No matter what size your business is, trade finance is usually a catch-all term for making import and export transactions for international trade.
But what are the important elements that make it work so well?
As an owner of a business - especially SMEs - you would want to reduce certain risks to the greatest extent, such as
- Avoiding complications like volatile exchange rates that risk your trading process, or
- Having your cash flow get tied up in shipments for weeks to wait for the overseas manufacturer to arrive.
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.
More than 80 percent of global trade relies on trade finance or credit insurance, which is why SMEs and many types of small businesses need trade finance products to help with global shipments and other business functions.
Understanding how each type of trade finance product works, its features, and benefits may help to boost your business trading process.
📑 Read more: How to Avoid Currency Exchange Rate Risk
Types of trade finance products
There are several types of trade finance products that many businesses commonly used. Oftentimes, SMEs would rely on these types of trade finance products for better and smoother operations.
Aside from small business owners, the other common users of trade finance can also be producers, exporters, or importers.
What these types of users usually have in common is their reliance on global shipments.
In this section, we'll explore 3 common types of trade finance products, including Letter of Credit (LC), Purchase Order (PO) Finance, and Supply Chain Finance.
1. Letter of Credit (LC)
To put it simply, a letter of credit is a pledge for making a 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.
⚡ Important: As collateral for issuing LC, banks would typically require a pledge of securities or cash.
Types of Letter of Credit
There are different types of Letter of Credit available, 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.
Benefits of Letter of Credit
There are many benefits when using a Letter of Credit as your trade finance product, such as:
- LC offers more security while building better reliability on payment for the seller.
- Provide a precise timeline for the completion of transactions for all parties involved for a streamlined payment.
How Letter of Credit Works
Usually, when the importer (aka the buyer) wants to purchase products from an exporter (seller), the buyer will reach out 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.
2. Purchase Order (PO) Finance
Purchase Order (PO) finance is designed for SMEs who face inefficacy or 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 them. 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.
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 are not accepted)
- Profit margins of 15-20%
- Creditworthy customers
- Reputable suppliers (manufacture & deliver products to customers on time)
💡Tip: Lenders focus on three major factors for PO Finance qualification: the size of the order, the creditworthiness of the customer, and the profit made on high-volume orders.
Benefits of Purchase Order Finance
Using PO as part of your pre-shipment solutions can offer plenty of benefits, which are:
- The ability to grow sales and maintain more inventory even when you're limited by capital.
- Increased funding from invoices beyond the timeline set.
- Avoid diluting ownership or piling bank debts through purchase orders.
- Easy repayment terms, as the risks of the collection are mitigated by lenders.
How Purchase Order Finance 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. However, the problem with this is that not all bank requirements can also be satisfied.
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.
Benefits of Supply Chain Finance
There are two major individuals involved when it comes to Supply Chain Finance - a supplier and a buyer.
Thus, if you're a supplier, here are some benefits you can expect to gain from this trade finance product.
- Instead of having to wait for the 30-day credit terms, the suppliers can be paid earlier;
- Insurance is provided to reduce financial risks;
- Provides liquidity
On the other hand, if you're a buyer, the benefits of using Supply Chain Finance are:
- Enables buyers the ability to purchase in bulk to save costs;
- Can work with complex end-to-end supplier chains;
- Maintains a healthy balance sheet
How Supply Chain Finance 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 by providing short-term credit.
This can optimize the working capital and make the cash flow more flexible for both parties.
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.
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 and its products 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.
Want to have your international payments taken care of and risks managed at the same time?
Open a business account with Statrys and get access to multi-currency accounting and FX trading services which can round out your trade finance needs.
What are common types of trade finance products?
Some common types of trade finance products used in a business are:
1. Letters of Credit (LC)
2. Purchase Order (PO) Finance
3. Supply Chain Finance
Other types of trade finance products may include bonds, standby credits, and guarantees.
How does trade finance work?
What should I be aware of in a trade finance transaction?