When trading goods internationally, an exporter would ideally need the importer to prepay for the shipment, and the importer requires proper documentation and assurance of the goods shipped.
This allows for reducing risk for both parties. Trade finance serves as a medium for smoothening international trade between both transacting parties and bridging the financial gap.
Meaning of Trade Finance
Trade finance refers to financial instruments and products used by organisations to ease international trade.
It makes the process of conducting international transactions easier for both exporters and importers.
It collectively refers to various financial instruments that make trade between companies more feasible.
Four Pillars of Trade Finance
Trade finance is built on four pillars, which are:-
Payment The reason for using trade finance is that it provides timely, verified, and secure payments across countries for commerce.
It deals with payment transfers and sets predefined conditions to mitigate any disputes between exporters and importers.
Risk Evasion Trade finance is equipped with tools that can minimise risk in case it arises.
The products and services offered as part of trade finance allow for risk mitigation between exporters and importers.
Finance The trade finance process acts as a financial bridge between importers and exporters and makes their international trade more viable.
Offering flexibility and numerous options that are adaptable to various geographic, political, and legal jurisdictions allows for more convenience in trade for the organisations involved.
Information An essential pillar of trade finance is to provide accurate and timely information regarding every detail of shipment and trade transactions at every stage.
This is not just limited to a sense of assurance about the shipment or transaction status; timely and accurate information also gives organisations efficiency and competitive advantages.
Trade Finance Products
Trade finance products and solutions come in various forms that offer financial support to ease the dealings between importers and exporters for international trade.
The most common ones are:
- Working Capital Limits
- Letters of Credit
- Invoice Discounting
- Export Credit (Packing Credit)
Process of Trade Finance
To facilitate the trade financing process, a third party or intermediaries such as banks or trading companies get introduced to mitigate supply and payment risks between importers and exporters.
It provides the exporter or seller with payment facilities or receivables as per the contract agreement, and the importer or buyer will be granted a credit extension to fulfil its obligations of trade order.
Trade financing aids in international trading complications such as political instability, non-payment risks, currency fluctuations.
The application process for trade finance is as follows:
1. Gathering Applicant Information - The prospective lending institution will gather information on the business that has applied for seeking finance to understand its debt finance utilisation.
2. Evaluating Applicant - From the information collected pertaining to the applicant, the trade finance institution will conduct a thorough credit evaluation to see the risks associated with lending finance to the applicant.
3. Negotiating Terms - If the company is approved for trade finance, both parties will negotiate favourable terms and prices to structure an agreement.
4. Approving the Finance - After checking the collateral viability of the seeking party, the loan will be drafted and signed by the lending institution, who will then approve the trade finance agreement.
// Also Read : Line of Credit | Meaning, Interest Rate, Uses & more
Benefits of Trade Finance
The benefits offered by trade finance to the parties involved are:
Enhances Business Cash Flow and Efficiency By helping companies obtain funding, trade finance lets organisations facilitate their operations. It ensures that delays in payments and shipments get reduced, letting both parties (exporters and importers) to plan their cash flow needs efficiently and improve their operations.
Reduces Financial Risk A company may miss out on paying its timely dues and risk losing suppliers or customers without trade financing.This can have a long-term negative impact on business operations. By offering options of funding like, accounts receivable financing, letter of credit, and more will facilitate international trade and mitigate monetary difficulties for participating organisations in many ways, such as reducing the risk of importer’s non-payment.
Increases Revenue Trade finance can help organisations increase their revenue stream as it helps to free them of their working capital needs, which otherwise gets utilised for paying off suppliers. It can also acquire the needed cash to increase its production and meet its demands smoothly.
Method of Payment
Exporters and importers tend to make use of the services provided by intermediaries to reduce their non-payment and supply risks, respectively.
Trade transactions are required to be made in a timely manner so as to foster a healthy relationship between the trading parties. When looking for methods of payment, organisations should understand the benefits and risks associated with the varying payment methods.
Some of the most common methods are cash advances, letters of credit, or documentary collections.
However, when the trust between the exporter and importer increases, they may consider an open account as a feasible payment method.
Payment using Open Account In the case of an open account payment method, the seller receives the payment from the buyer after the goods have been delivered to them.
This can typically range from 30, 60, or 90 days.
This transaction method is more beneficial to the buyer and increases the risk for the seller. The open account came into existence as it created a boost in export market competition.
However, this method is chosen only when the relationship between the buyer and seller is strong.
To protect themselves from insolvency, bankruptcy, or default payment by the importer, exporters can use trade credit insurance.
Parties Involved in Trade Finance
There are various organisations involved in the trade finance ecosystem and can include:
- Importers and Exporters (buyer and seller)
- Trade Finance Companies
Trade Finance Company A trade finance company or provider is a third-party institution that lends funds to the borrowing business and aids their trading activities.
It assesses the creditworthiness and risks associated with the borrower, and based on it, decides the viability of extending them the trade finance.
They offer various trade finance services and products for international trade and commerce.
Difference Between Trade Finance and Export Finance Trade finance provides financial assistance to sellers and buyers to reduce their payment and supply risks for international trade.
Export finance is a type of trade finance that provides funds to exporters letting them sell their goods (manufactured domestically) and services overseas by extending a guaranteed or advance payment giving a boost to their working capital.
Risks Associated with Trade Finance
When trading goods, there are various risks that the parties involved may face. These include:
- Supply Risk
This may arise when the importer may not receive the delivery of goods from the exporter after they prepay for the shipment or if the shipment gets damaged or lost while in transit.
- Payment Risk
This risk is associated with the exporter not receiving its payment from the importer even after the delivery of goods.
- Currency Risk
This is related to the fluctuations in the currency rate during international trade affecting the payment of goods.
During the credit period in which the buyer is supposed to pay within 60 days if the currency rate fluctuates 15 days prior to payment then it causes a financial risk for the seller.
- Political Risks
Incase of any political instability and changes, the trade between the buyer and seller could hamper and cause a strain to both parties.
- Documentary Risks
If the document necessary for international trade is inaccurate or missing vital information then it causes delay in shipments which in turn impacts the payment of goods.