Trade finance is a type of business funding that helps to ease the risks associated with international trade. It offers protection to both importers and exporters by introducing a third party into the deal, in the form of a financier. The financier helps to mitigate potential dangers relating to the payment and supply of goods.
Why is trade finance needed?
Business trade is inherently fraught with risk. When dealing with partners in overseas markets, the dangers are amplified further still. The companies you are trading with are not bound by the same laws and protections as you, so the business of importing and exporting becomes a risky operation.
This is where trade finance comes in. It protects importers and exporters against the perils associated with international trade.
The two main risks when trading internationally relate to:
- The party you’re dealing with: Will the goods you’ve shipped be paid for? Will the product you’ve paid for be shipped? How creditworthy is the company you’re dealing with?
- The country you’re trading with: What will happen to the exchange rate? How is the economy? The political situation? What protections are offered by law?
In an ideal world, the company exporting would like the payment upfront before they ship the goods. This removes the risk that the importer doesn’t pay. But what if you’re the importer, you might pay upfront and the exporter then doesn’t ship.
Trade finance reconciles these divergent needs. It eases risks and facilitates trade across borders. This, in turn, allows businesses to grow and secure deals that otherwise would be impossible, or at least unwise.
How does trade finance work?
It works by introducing a third party into the equation. This party, the trade finance company bridges the gap between the importer and the exporter. They alleviate payment and supply risks.
For the exporter: A letter of credit is provided to the exporter, which works as a guarantee they’ll be paid. Once the goods are shipped, the exporter forwards the proof (known as a bill of lading) and the payment is released to them.
For the importer: Credit is provided with which to make the trade. The financier also offers protection in the form of credit insurance, should the goods not arrive.
In actual fact, there are often 4 parties involved as both the importer and exporter are covered by trade finance. The two financial institutions (the importer and exporter’s banks) work together to facilitate the transaction. Sometimes known separately as import or export financing, trade finance describes the broader arrangement in which all parties are involved.
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.
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.
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.