Due to the differences in regulations and the distance between countries, it can take a considerable amount of time for businesses to receive goods after placing their order from overseas vendors. This can be challenging for small businesses as they may have insufficient funds to meet their short-term cash requirements while waiting on their import deliveries.
Such businesses generally retain cash at hand and fund their international purchases through import financing.
Import Financing: Meaning
Import finance refers to trade financing solutions that are available to businesses for funding the purchase of goods internationally.
These solutions help businesses preserve cash to fund ongoing operations while enabling them to buy goods to meet future demand.
As a result, import financing allows traders to eliminate their cash flow troubles. and fund their growth plans.
An Example of Import Finance
For instance, company A, a steel goods manufacturer from the US plans on importing a large amount of raw steel from company B in China, where steel is cheaper.
Since company A does not have enough cash at hand to pay for the raw materials, it decides to opt for import financing. It can consider all its available import financing options, of which it decides to use buyer’s credit from the EXIM bank of China.
Here the EXIM bank can offer credit to company A, which it can use to pay company B as soon as the steel is delivered. Company A can even leverage its ability to make an instant payment to get more favorable rates from company B. Then, after selling its manufactured steel goods, company A can repay the EXIM bank.
Uses of Import Financing
In addition to optimizing cash flows, the need for import financing occurs for several other reasons, including risk hedging. Import finance is also considered an excellent financial option that comes in handy to meet working capital requirements. Most of these loans also come with flexible repayment timelines, which helps businesses plan their finances to repay their debts conveniently. Import financing also enables businesses to maintain strong and long-term supplier relationships. The inflow of cash due to import financing helps businesses pay their suppliers promptly, ensuring healthy relationships, enabling efficient, and faster supply chain operations.
In the US, international trade financing has been on a steady rise since the pandemic and currently stands at $625.4m as of 2022, which is 5.1% more than the previous year. Import finance plays a crucial role in enabling US-based businesses to source goods and materials at competitive prices from across the globe. As a result, they are able to meet growing domestic demand while maintaining healthy margins. Depending on a business’s cash flow, seasonality, and other factors, different modes of import financing can offer different advantages. Hence, it is imperative for companies to critically evaluate which trade financing option would suit them the best.
Parties involved in an Import Finance Transaction
There are several parties involved in an import finance transaction, including-
- Trade finance companies
- Importers and exporters
- Export credit agencies
- Other service providers
Any international transaction, whether it involves importing goods to sell on the market or exporting them and generating working capital for operational needs, has its ultimate goal as the growth of the business.
Import finance stands at the center of all of this to speed up procedures and reduce the risks involved in international trade by employing methods of international trade finance for both parties.
These numerous choices for import financing can ultimately help businesses increase their working capital, resulting in business expansion.
What are Popular Import Finance Techniques?
Businesses can receive import financing through a number of methods:
- Inventory Finance
Inventory financing is an import financing option where businesses procure funding to purchase inventory. These loans are typically taken to support the purchase of products that are not meant for immediate sale. Inventory financing can be done in the form of loans, lines of credit, or even an equity exchange.
The collateral against which the loan is taken is the inventory itself. If the businesses cannot repay the loan, the financial institution or the lender can seize the stock that was purchased using the loan.
Hence, for this method, the resale value of the goods is of utmost importance. Businesses take up inventory loans to keep up with unpredictable spikes in demand or to update their product lines. These loans can also be used to stock up on products that have seasonal demand.
Companies prefer this type of financing because it does not require lenders to rely on personal or business credit history and is comparatively easy to get approved.
- Letters of Credit
An LC or a letter of credit is a document that the importer's bank (opening bank) issues to the exporter's bank. Through this document, the exporter is guaranteed that the issuing bank will pay the supplier for cross-border trade between parties.
A letter of credit is advantageous to both parties since it ensures that the seller will receive their money after delivering the goods as agreed. The seller can leverage the bank’s support to demonstrate their creditworthiness and bargain for more favorable payment terms.
The letters of credit used in international trade can be issued either as revolving or non-revolving letters of credit.
A revolving letter of credit means that once the payment has been made, the funds can be drawn again. It works similar to a credit card for businesses. A non-revolving one is more similar to a one-time loan.
A letter of credit is just a guarantee, and if the importer cannot pay, the bank steps in and pays the exporter. This makes a letter of credit beneficial for the exporter but potentially risky for the banks.
- Supply Chain Finance
Supply chain financing (SCF) is when a third party enables a trade transaction by financing the supplier on the buyer's behalf. It is also referred to as supplier finance or reverse factoring.
Contrary to the traditional transaction, the buyer or importer opts for supply chain financing solutions and approaches the lender when a supplier requests early payment for their goods.
One of the cases where importers might use SCF is when their vendor requires the payment to be done before the due date. In such a case, the third party will pay the amount to the seller, and the buyer will pay the third party when the due date arrives.
This way, both parties are secured — the seller has the cash to fulfill the purchase order and the buyer can retain their cash until the goods are delivered. Until recently, SCF was only available to large businesses, but is now available to all businesses, making it an easy import financing option.
- PO funding
When a third party agrees to fund a business's purchase orders, it is called PO funding or purchase order funding. Distributors, outsourcers, resellers, and wholesalers of imported goods can use this kind of funding. Businesses with uneven cash flow, who need to purchase goods before fulfilling orders, typically use this type of financing. Purchase order loans can fund the complete order in some circumstances while partially financing it in others. The payment for the goods is directly made to the PO funding company, who will, after deducting their fees, send the balance to the borrower.
Importers can use this method because they can keep operating without disrupting their operations due to a lack of cash flow. PO funding organizations do not necessarily look at the organization's credit history since their payment comes directly from the customer. This provides them with a guarantee of future payment. The lender is interested in the creditworthiness of its customers rather than the importer themselves. It is also significantly easier to obtain these kinds of loans. These work out well for small businesses planning to expand and are worried about funding their next order.
- Bank Guarantees
A bank guarantee is a written guarantee issued by the bank to the seller, which states that if the liabilities of the buyer are not met, the bank covers them. A bank guarantee allows importers to buy equipment and goods or draw out a loan. Since these loans come with a higher risk to the lender, bank guarantees come with higher interest rates and a thorough credit history check. A bank guarantee is different from the letter of credit. A bank guarantee is encashed only if a payment fails, while the letter of credit is surely encashed after the terms are fulfilled. Generally, bank guarantees are used when a small importer buys from a significant international institution.
- Buyer's Credit
A buyer's credit is a short-term loan issued to an importer by a lender from the exporter's country — which could be a bank or another financial institution — to finance the purchase cost. It gives access to funds to the buyer at cheap rates as compared to what would be available domestically in the US. An export credit agency guarantees this loan to reduce the risk for the exporter. Since this type of financing involves many parties and legalities across borders, it is only available on large orders. Businesses choose buyer's credit because, with this, the exporters are guaranteed the payment on their due dates. It also allows the sellers to execute huge orders while providing the importers the flexibility to pay. The funding can also be done via a stable domestic currency to avoid excessive fluctuations. The exporting country’s export credit agency has a crucial role to play here since it protects the lending institution from political and economic risks.
- Invoice Factoring
Invoice factoring is when businesses "sell" their invoices to a third party. Unlike PO financing where a business seeks funding using the PO of an unfulfilled order, invoice factoring uses an invoice of an already fulfilled order. This invoice is given to a third-party factoring company that verifies it and provides the business with payment equivalent to up to 70-80% of the accounts receivables. This is known as invoice discounting. The factoring company collects the invoiced amount directly from the customer. Once this happens, the factoring company deducts its fees and pays the outstanding amount to the seller. Businesses with many outstanding invoices and insufficient cash flow can opt for invoice factoring to import goods or materials. Importers in immediate need of financing can use invoice factoring to finance their business at a discount.
Forfaiting is when an exporter sells their medium and long-term foreign accounts receivable to a forfeiture, which can be a finance firm or a department in the bank. When pursuing sales with international buyers who require more extended financing periods that can last for months or years, forfaiting can assist exporters in improving cash flow. Importers in the US can benefit from this option to procure capital goods by producing a letter or credit or bank guarantee to the forfaiting bank, if the seller agrees to opt for forfaiting. Learn more about forfaiting in this dedicated post on the topic.
Short Term VS Long Term Import Finance Options
The primary difference in the types of import financing loans is the duration. But along with this duration, several other differences come into play.
Advantages of Import Financing
Increased Cash Flow: Import financing provides businesses with the necessary funds to purchase goods from foreign suppliers. This helps to increase their cash flow, allowing them to focus on other aspects of their business.
Reduced Risk: Import financing can help reduce the risk associated with importing goods from other countries. With the help of financing, businesses can ensure that they have the necessary funds to pay their suppliers, reducing the risk of default.
Enhanced Creditworthiness: Import financing can help businesses enhance their creditworthiness by establishing a track record of paying their suppliers on time. This can help them secure better terms and rates for future financing needs.
Greater Flexibility: Import financing can offer businesses greater flexibility when it comes to managing their cash flow. With a range of financing options available, businesses can choose the one that best suits their needs and requirements.
Overall, import financing can be a valuable tool for small businesses looking to expand their product offerings and reach new markets. With the right financing in place, businesses can minimize risk and maximize profits, helping them to grow and succeed in a competitive global marketplace.
FAQs on Import Financing
Q. Who provides import financing? A. Banks, financial institutions, and other specialized lenders provide import financing.
Q. What documents are required for import financing? A. The required documents may vary depending on the type of financing. Generally, importers need to provide purchase orders, invoices, shipping documents, and insurance certificates.
Q. What is the difference between LCs and Documentary Collection? A. LCs are a more secure form of financing as the bank guarantees payment to the seller. Documentary Collection, on the other hand, involves the release of shipping documents to the buyer only after the payment has been made.