August 11, 2022

What is Trade Finance?

Trade finance is most commonly known as a type of working capital finance, it is an umbrella term that covers businesses that are importing and exporting goods around the world, and which partake in intentional business transactions. It can work alongside or in conjunction with other working capital solutions such as Invoice Finance and Supply Chain Finance. Trade finance solutions are described as enabling the buying and selling of finished goods between two businesses. Thus, trade finance can only be used when there is a confirmed purchase order in place from the business’s customer. Once there is a purchase order in place, the trade finance solution enables the business to purchase the finished goods as soon as possible, allowing goods to be shipped without leaving a delay or tying up the business’s own working capital. 

For example, if your business exports goods there is typically a gap between the goods arriving at their final destination and the business receiving payment. This is where a trade finance lender can fund the gap while the business waits for payment from overseas, in some cases this can take up to 90 days. 

If the business is an importer, the business won’t want their capital tied up in the shipment of goods as this could take a number of weeks to arrive.    

Trading internationally can pose many risks, there are all sorts of external factors, shipment delays, non-payment, political issues and so on. The most common way of a trade finance provider mitigating these risks is via a letter of credit. 

What is a Letter of Credit?

In short, letters of credit are used as a way to guarantee secured payment settlements with international trades. The letters of credit are typically issued via a buyers bank, this provides a seller with a payment guarantee, confirming that the payment will be received as stated in the terms and conditions of the letter of credit. If a payment from the buyers isn’t completed, the bank who issued the letter of credit would make the payment to cover the costs to the seller. A letter of credit is an instrument used between importers and exporters as the distance makes it hard to evaluate the reliability of the business you are trading with. Additionally, every country has its own rules and regulations.  

In principle, trade finance and the financial instruments that are used in combination can diminish the potential risks of international and domestic trading. 

What is a Typical Trade Finance Solution?

  • The business is provided with a credit limit – agreed by the lender 
  • An order is placed with the supplier 
  • The lender pays the supplier straight away once a letter of credit has been issued (or other documentation such as a shipping confirmation) 
  • The supplier ships and delivers the goods to the agreed location 
  • The business pays off the finance including interest, typically within a 90 day period (some businesses will use invoice finance in-conjunction to pay off the finance quicker) 

Trade Finance and Invoice Finance

In some trade scenarios, it can take a couple of weeks for the goods to be shipped and arrive once an order has been placed, the customer then pays on 45-day payment terms, leaving the business out of pocket before they eventually receive payment. Trade finance elevates the waiting time and payment gap but the 45-day payment term can still cause working capital gaps. Hence if the business has an invoice finance facility in place the business is able to bring forward the waiting time, allowing the business to realise the capital in the invoice straight away. Across the market, trade finance providers will often offer invoice finance solutions as well, however there are stand alone trade finance providers that don’t require invoice finance alongside. This is mainly dependant on the type of business and the financial stability of the business and the businesses they are trading with. 

What are the Costs Associated with Trade Finance?

The main cost connected with trade finance facilities is interest rates, with the rates being applied on a monthly basis. The typical interest rates per 30 days are between 0.8% and 3%. There can be other costs that a business might want to consider such as credit protection insurance, which protects against non-payment from a customer. This cost is typically included in the interest cost of the facility. 

What are the Advantages of Trade Finance? 

  • Competitive Advantages: The primary advantage of trade finance solutions is to reduce the overall risks that come with international trading. This can facilitate competitive advantages for the business such as reducing the risk of non-payments as well as associated territory risks. Thus, maximising the potential of the trade cycle.   
  • Boosts Buyer/Seller Relationships: As trade finance enables the business to pay suppliers quicker and most of the time in their local currency this facilitates building confidence between the business and their suppliers which is a crucial relationship to maintain.   
  • Growth: As trade finance allows to reduce payment gaps, this fees up additional working capital that is the key to all businesses. Thus, allowing the business to use their freed up working capital to invest in more orders or other areas of the business which they wouldn’t be able to do if the facility wasn’t in place. 

What are the Disadvantages of Trade Finance?

  • Additional Cost: Clearly trade finance doesn’t come without the related costs, all facilities are short-term solutions and typically come with monthly interest rates. Therefore, if businesses are using trade finance solutions regularly the cost needs to be factored into the margins of the goods being imported or exported. 
  • Confidentiality: All parties will be aware that there is a trade finance facility in place as the finance provider will be in touch directly with the business’s customers for payment. Meaning the credit control is now in the hands of the trade finance provider, this can sometimes damage the relationships that the business has worked hard to build up over time.

Provide’s team of financial experts can help you understand how trade finance can work with other financial instruments to mitigate risks in your business. Our platform will connect you to over 200 lenders so you can find the lender who meets the criteria for your business’s specific needs.

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