Specialist finance

What is trade finance?

Trade finance (also known as export finance) is a form of financing for international trade. It covers every stage of the supply chain process, from the purchase order to payment for goods or services. Businesses often use trade finance to make payments outside their country or region. However, it can also be applied in domestic situations if the selling party wishes to retain ownership of an asset until they have been paid in full (e.g. real estate agents).

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What is trade finance?

Trade finance is a type of working capital finance that provides a company with the funds it needs to buy and sell goods. It is used for international trade in general and for import and export of goods.

For example, an importer buys products from overseas manufacturers, who deliver them to the importer's warehouse. The importer pays for these products by giving their bank an irrevocable letter of credit (ILC) which states that if certain conditions are met by the exporter (e.g., delivery or shipment), then the importer's bank will pay this amount of money as soon as possible after receipt by them.

Why is trade finance needed?

Trade finance is needed because it's expensive and risky to ship goods from one country to another. It can cost tens of thousands of dollars to get a container ship from one country to another, and there are many risks involved with each shipment. For instance, if you're shipping something like electronics from China, then there's a chance that your products will be damaged in transit or customs agents won't allow them into the country at all.

If your company sells its goods internationally, trade finance may be able to help mitigate those financial risks by allowing you to sell through channels that have already proven themselves trustworthy and secure. In addition, some types of trade finance can help protect against other types of risk, like currency fluctuations or political instability in foreign countries.

How does trade finance work?

Trade finance is a financial service that helps businesses trade across borders. Sometimes, it's called export finance or import financing. These services help companies buy and sell goods and services with partners in other countries.

When you do business with a company abroad, you have to exchange money between your currency and theirs. For example, if you are selling products to customers in Europe and they want their money paid in euros (€), then at some point before the sale is complete and your customer pays you back for those products, there has to be an exchange rate set so that both parties agree on how much each party should receive.

This means that if one party doesn't trust the other party enough to pay them back after making a deal on a purchase order worth €50k but only exchanges $45k for €50k ($1 = €0.90), then there could be problems down the road when it comes time for payment from one side — either through refusing outright because they don't have enough cash available or by delaying payments until they can get more money into their account.

How does trade finance reduce risk?

Trade finance can reduce the risk of financing, fraud, non-payment, and currency fluctuations. A secure trade finance system reduces the risk of financing by giving companies access to various financing options for their international transactions. For example, suppose your company has an importer who wants to buy goods from you but doesn't want to pay for them up front (a common scenario). In that case, you'll be able to use different types of trade finance instruments like factoring or letter of credit to purchase those goods on behalf of your importer while they're still being made. This allows your importer to focus on selling goods and services while allowing you to focus on making them.

With a secure trade finance system in place:

There's no need for cash upfront because all parties are protected under a letter of credit or another type of instrument that removes risk until payment is due

You don't have to worry about whether or not an invoice will be paid because an institution guarantees it

What are the risks of trade finance?

The risk is that you don't get paid. It's as simple as that, really. The risk for an importer is that their goods will be shipped and then not picked up by the consignee (the person who ordered them) or not paid for by them.

This can happen for a variety of reasons, including: the buyer has gone out of business, they've become insolvent, or they don't want to pay because they changed their mind about buying your product. The risk for an exporter is when things go wrong with shipping and/or clearing customs at entry ports abroad—and delays in delivering goods can cause cash flow problems if there aren't enough funds set aside to cover costs such as storage fees while waiting on payment from customers overseas.

Is trade credit a long-term source of finance?

Trade credit is not a long-term source of finance. Trade credit is a short-term source of finance. Trade credit is not a loan; rather, it's more like borrowing against your future sales.

Let me explain: when you buy something on credit, you can pay for it later at your convenience – however, there are often restrictions on how much money you can spend and where you can spend it (especially if the seller or lender has any concerns about their security). With trade credit—or "revolving lines of credit," as they're called in the industry—the buyer usually gets access to an unlimited amount of funds that the seller has pre-approved. This means that businesses use trade credits to buy goods and services in advance without having to go through traditional lending channels such as banks or other financial institutions because they know exactly how much money they will be able to borrow from each client (and therefore make sure they won't get stuck with too many invoices).

What risks does it cover against?

Since the companies trading with one another are not governed by the same set of laws, resolving disputes should something go wrong can be difficult, if not impossible. A typical trade finance product helps by mitigating a broad range of risks:

  • Will the business exporting the goods be paid? It alleviates this payment risk by releasing funds upon proof of shipment.
  • How will the importer deal with cash flow issues? It offers credit upfront, so the exporter gets paid immediately, whilst giving the importer time to settle the debts.
  • Will they receive the goods they ordered? It offers protection, such as credit insurance to cover the order.
  • What about currency fluctuations? Transactions are guaranteed based on a fixed rate.
  • Political or economic stabilities It offers protections when dealing with a country that may be undergoing unexpected changes.
  • The creditworthiness of other parties

By offering the above protections, it can help to alleviate some of the unknowns about the business you are trading with.

As well as reducing the risks associated with international trade, it can also benefit both businesses in a number of other ways:

  • It can help businesses grow. They can secure deals that would have otherwise been too risky or not possible.
  • Access to cheaper stock or raw materials. They can order from overseas markets without the worry that goods won’t arrive.
  • Fewer payment delays. Cash flow gaps are alleviated as invoices are paid upon shipment of goods
  • Don’t have to turn away further business. The immediate payment to the exporter brings cash flow benefits. They can fulfil more orders, hire more staff and grow.

Other types of business finance

Business line of credit

Like a business overdraft but needs to be applied for separately and often comes with bigger limits and is for planned expenditure. A revolving line of credit where funds are drawn on continuously. Repayments are flexible with interest charged on the daily balance.

Used for planned expenses such as operating costs, payroll and raw materials / stock.

Business overdraft

Similar to a line of credit or a credit card. A common type of business funding that is attached to a transaction account. Funds can be borrowed to an agreed limit with interest charged daily on that amount. Funds can be drawn on again and again without the need for reapplication.

Used for cash flow, unexpected expenses and opportunities.

Business credit card

Like an overdraft or a line of credit, but not recommended as a regular source of business funding. Can spend up to an agreed limit and balance must be repaid or high interest rates apply.

Often uses by businesses for short term expenses and paid off quickly (within the same month) to avoid charges.

Invoice finance

Used by businesses to ease cash flow issues caused by credit terms on invoices. After delivering a good or service, a supplier will have to wait for payment. Funds are secured using the accounts receivable ledger, either by selling it or using it as security.

Two main types; invoice factoring, where the ledger is sold to a third party, and invoice discounting, where it is used as collateral for funds, but collections remain the responsibility of the business.

Used to ease working capital issues created whilst waiting for invoices to be settled.

Other loans types

Other types of finance include equipment finance and supply chain finance. These apply to businesses within certain industries and trading with specific equipment or partners.

Disclaimer: always refer to professional advice. The information presented here is purely indicative and not intended as advice. Always consult a legal or finance professional.

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