Understandably, many businesses may wish to trade internationally. Fortunately, trade finance concerns all of the different factors that allow companies to achieve this. Its purpose is to relieve and reduce the risks that may be associated with international trade.
Trade finance is usually used by businesses who are already actively trading as your lender is likely to want to see track records.
In this article, we will cover what trade finance is, how it works, how you can access it, and look over the pros and cons, so you can feel more informed.
What is Trade Finance?
Broadly speaking, trade finance refers to the financial instruments and tools companies use to be able to enjoy international trade.
It adds a third party to bridge the financial gap between buyers and sellers. This, in turn, reduces risk and essentially makes it easier to trade overseas.
Types of trade finance solutions
As trade finance is an umbrella term, there are various parties involved who can offer solutions including banks, insurers, importers, exporters, trade finance companies, export credit agencies, and providers.
They can provide services and solutions to assist businesses, such as the following:
- A letter of credit is where a buyer’s bank agrees with the exporter that they will immediately issue payment once the transaction is finished. These reduce some of the potential risks of global trade as the importer’s bank had guaranteed the payment to the seller.
- Lending lines of credit is a preset borrowing limit that customers can draw from when they need funds. These can be issued by banks to support both importers and exporters.
- Export credit is a type of financial support or working capital that is supplied to exporters.
- Insurance can be relied on as a form of protection for the exporter if there is nonpayment from the buyer. It can also be used to cover shipping and delivery.
- A bank guarantee is where the bank serves as a guarantor if the buyer or seller fails to satisfy the terms and conditions outlined in their contract. In this case, the bank will pay money to the beneficiary.
- Factoring is a type of financial transaction where the business sells its accounts receivable (such as invoices) to a third party (who is the factor) but at a discount.
- Forfaiting is similar, as it is when a seller trades the entirety of their receivables to a forfaiter, again at a discount, in order to receive instant cash.
How Does Trade Finance Work
International trade has various risks involved, which are often out of the control of the seller. For example, shipments can be impacted by factors such as natural disasters, regulations, and politics.
Also, there may be unease amongst the importers and exporters in the first place. For instance, an exporter would likely prefer an importer to pay upfront to avoid the chance that the importer will take the shipment but then not pay.
Likewise, an importer may want the opposite. In this case, the buyer may want the exporter to ship first in case they accept the payment but then not dispatch the goods.
Trade finance acts as a cushion by providing security and solutions for all involved. It mitigates the unforeseen potential risks involved with global trade.
An example of trade finance
Let’s say a haircare business wants to sell its products overseas. They may rely on trade finance to take some of the stress off their shoulders and cut down the risk of global trade.
A deal may be made for the trade transaction by involving a bank that will act as a third party. They agree to use a letter of credit as security. Here, the importer will send the payment to the haircare business after the items have been shipped. Therefore, the haircare company doesn’t have to worry about shipping the items only to not receive the payment.
Likewise, the importer doesn’t have to worry about not receiving the products as it was verified by the bank.
How Can I Get Trade Finance?
To access trade finance there is not one universal route as different lenders will have various requirements and criteria to provide loans. It will also depend on the lender – whether it’s a bank or another third party. It is worthwhile exploring all of your options to find what best suits you.
That being said, the process should follow these approximate stages:
- A credit application should be made to the lender, where you will likely be asked for information on your financial statements, budgets and forecasts, assets, any liabilities, trade cycles, purchase orders, and current invoices.
- The lender will likely undertake a full credit risk assessment of the information and documents you have provided to determine your risk.
- If you are eligible, you can enter negotiations with the lender.
- You may then get approved, at which point you’ll have to sign documentation contracts of the loan.
How long does it take to arrange trade finance?
The time it takes to arrange the trade finance will vary depending on its complexity and other factors. However, trade finance typically takes between one and four weeks to arrange.
Who Provides Trade Finance
Trade finance can be provided by banks or other third parties. However, it’s worthwhile noting that larger banks such as HSBC and Barclays tend to only work with established businesses. Likewise, some large independent lenders will only offer trade finance if it’s combined with invoice finance.
That being said, various lenders will provide trade finance as well as invoice financing or a combination of both. Some lenders who provide trade finance include Ebury, Hilton-Baird, Rangewell, and the FSB Funding Platform which can also be useful.
You can also find some specialist lenders who provide standalone trade finance.
Why Would You Use Trade Finance?
Trade finance helps you cover bases like a safety net in the event that trade transactions fall through in one way or another. As a result, it can help your business’s cash flow.
For any businesses that partake in international trade, trade finance can be incredibly beneficial as it ultimately mitigates its associated risks. In fact, the World Trade Organization (WTO) states that 80 to 90% of world trade relies on some form of trade finance.
Does My Business Qualify for Trade Finance?
Different lenders may have different criteria and requirements for who can qualify. However, if you import or export goods and your business has a reasonable business chain, it could be a good option to consider.
What Are the Costs of Trade Finance?
It is worth keeping in mind that taking out finance will, in turn, make the trade transactions less profitable as you will be paying interest on the loan.
Generally, interest rates will fall anywhere between 1.25% and 3%, with larger orders often having a lower rate of interest. The cost of the finance will also vary depending on who the supplier and buyer are, their credit histories, and other factors that may affect their risk.
The Pros and Cons Trade Finance
As you might be able to imagine, there are various advantages and disadvantages to using trade finance products, so we’ll take a look over some of them:
- It can improve cash flow as the buyer’s bank will guarantee payment and they know the goods are going to be shipped.
- Can improve the efficiency of operations.
- Can help buyers not miss out on a deal.
- Helps to secure orders and give peace of mind.
- A letter of credit may need to be cash-backed or involve collateral as security.
- Can become costly if repayments are not made on time.
- Your business may not be eligible.
Choosing the Right Trade Finance Option
When it comes to trade finance, you’ll have different needs depending on where you sit in the trade supply network. For example, if you are a seller, you are most likely going to want to look at export finance.
Likewise, if you are importing goods, your primary concern is going to be ensuring you receive the products on time.
As we’ve discovered, trade finance makes business overseas more secure and less risky for importers and exporters. It can improve cash flow and the overall business operations. However, that doesn’t mean trade finance has no downsides.
Unfortunately, as with many loans, most lenders will want security in the form of collateral and assets. This means if you are unable to repay, you may have to hand over the named assets. Likewise, if you are unable to make the repayments on time, it can become costly.
Furthermore, your business may not qualify for trade finance especially if you are a new company.
Overall, trade finance may be an option to consider if your business has been trading for some years and is wanting to extend its services overseas. We hope that you have found this article useful in informing your decision.
Can I use trade finance worldwide?
The purpose of trade finance is to allow your business to engage in world trade.
Many companies from different sectors and industries want or need to trade worldwide, and trade finance gives them the tools, means, instruments, and options to do so with minimal risk on either side.
Trade finance simply makes it easier to import and export goods all across the globe without having to be concerned about external factors such as country risk, payment risk, and supply risk.
What’s the difference between trade finance and supply chain finance?
Trade finance and supply chain finance (SCF) serve similar purposes as they both aim to finance domestic and international supply chains.
However, trade finance is typically used when the partners either do not know each other very well or even at all. This is where solutions such as letters of credit, insurance, and bank guarantees come into play to protect both parties.
On the other hand, SCF is usually used where importers and exporters have previously done business together.
In this case, the suppliers may receive early payments on their invoices. The purpose of this is to prevent disruption and improve efficiency for both parties.
What are structured trade finance transactions?
Structured trade finance refers to where a borrower, who is usually the seller, receives a loan to allow them to finance the production costs or to create cash flow. The transaction is known as structured because proceeds of the goods are then applied as repayment of the loan.
These loans, therefore, have unconventional security and provide order for the cash flow. It is seen as an alternative to typical lending and it is commonly used in developing countries and transactions across borders.
Why is insurance important for trade finance?
There are various types of insurance you can use for trade that can cover the shipping and delivery of the products, and protect the seller from non-payment from the buyer.
Some insurance types include trade credit, credit insurance, and political risk insurance.
Trade credit refers to an agreement to buy goods on account. This provides the buyer with a longer period to repay and helps free up their working capital. Trade credit can be particularly helpful for growing businesses.
Trade credit insurance protects the seller against non-payment from the buyer if there are risks such as bankruptcy, insolvency, and contractual disputes.
Finally, insurance for political risks serves as a barrier to protect businesses that are buying goods from politically unstable countries.
This protects them against acts beyond their control such as war and terrorism. It also covers them if they cannot make a payment due to the actions of a foreign government.