Types of Trade Finance & How it Helps with Working Capital

What is trade finance?

Trade finance is the financial assistance provided in the field of international trade and commerce through the use of various financial products. A plethora of financial products fall under the ambit of international trade finance, each of which is designed to ease the conduct of business among importers and exporters around the world.

Types of Trade Finance

The nature and purpose of trade finance are quite different from the usual financing of products and services. As such, trade finance products are unlike conventional financing products. Some typical trade finance products are listed below:

• Term Loans
• Working Capital Limits like Overfraft and Cash Credit
• Letters of Credit
• Invoice Discounting or Invoice Factoring
• Export Credit (Packing Credit)
• Insurance

Term Loans

In Term Loans, the amount borrowed has to be repaid in installments over a certain period of time. Usually this period is upto 10 years, but in some cases it can go upto 30 years depending on the financer. Such funds are given at a certain rate of interest which is to be repaid along with the principal amount. Term Loans are mostly used for a long term project, where the business is expecting the return of investment to come in after a certain period of time.

Working Capital Limits like Overdraft or Cash Credit (CC)

Overdraft and Cash Credit are types of lines of credit, which can help both importers and exporters to apply for cash as and when they need against it, as long as the line is open. These lines of credit are just another form of borrowing, the only difference being that this is a short term funding and interest here is charged on the basis of amount and period of utilization. Businesses are supposed to borrow small amounts from this line when they have insufficient balance in their current accounts for operational business transactions, and put it back as soon as they receive funds to avoid high interest charges.

Letters of Credit

Letters of credit are used to reduce the risk of non-receipt. The buyer’s bank provides a payment guarantee to the seller against the goods shipped. Banks are often ready to finance against Letter of Credit (LC) as there is an inborn security in an confirmed LC that the issuing bank will make the payment in case of default.

Invoice Discounting or Invoice Factoring

You can approach your bank or a financial institution and present your invoice to them for faster liquidation. The banker or the financial institution could purchase, collect, or even discount the bill. For example in Invoice Factoring you can submit your invoice along with certain other documents to Drip Capital, which advances up to 80% of the invoice value within 24 hours. On maturity of the invoice, the importer pays Drip Capital, which then settles the remaining amount after accounting for the agreed-upon fee.

Export Credit

One can avail pre-shipment finance from a financier against an export order received from the importer in the form of Packing Credit. Once the funds are received from the overseas buyer, the concerned export packing credit amount willbe adjusted and loan will be closed against that order.

Insurance

Export trade insurance products provide assurance against the shipping, payment, and the delivery of goods, which are designed to safeguard the foreign exchange receivable risk of the business.

How can trade finance help with working capital?

Trade finance speeds up the flow of business by making cash available more easily. For example, in the case of receivable discounting, the exporter receives cash against the invoice raised without having to wait for the credit period. Thanks to the cash or guarantee provided by the financial service provider, the importer or exporter can enter into transactions without waiting for the actual cash to arrive and without worrying about not receiving the goods or non-payment.

Trade finance products fit into specific parts of a business transaction and reduce the lag time for that part, either through an injection of cash or an assurance. This is helpful for the overall business and industry, but at a more micro level, it helps with the working capital of the exporters and importers.

Who provides trade finance?

Trade finance providers are third parties to the business transaction who effectively reduce the financial risk associated with the transaction or trade relation. Different types of financial institutions provide trade finance, and here are some notable ones:

• Banks are involved in various aspects of international trade and offer services like letter of credit (LOC)-based financing, supply chain finance, open account financing etc.

• Trade finance companies provide supply chain finance and letters of credit. Besides, they can provide structured trade finance, invoice factoring, receivables discounting, and other customised products.

• Insurers are also involved in trade finance in roles that are quite similar to banks. Their services include receivable finance, payable finance, letters of credit, asset-based lending, and term loans.

• Export credit agencies provide loans and insurance options to companies in the form of credit insurances and financial guarantees.

Trade finance vs traditional working capital products

Just as trade finance products offer working capital credit, traditional financing companies also have working capital financing products. Working capital financing can traditionally be availed of through cash credit, bank overdraft, working capital loan, bank guarantee, commercial paper etc.

Traditional working capital products can be used on an ‘avail when you need’ basis, as in the case of cash credit and bank overdraft. Also available are direct loans repayable against specific tenure and instalment, and to meet cash requirement.

Some finance products designed to meet working capital requirement are lines of credit, receivable discounting, and post-shipment factoring and financing. Unlike traditional financing, trade financing options like discounting and factoring are closely linked to the export trade itself and/or to specific sub-parts of a foreign trade transaction.

Benefits of trade finance for an export business

• Trade financers gauge the commercial viability of an export business and extend financial support based on their assessment. Thanks to trade finance, an exporter doesn’t need to liquidate their equity to attract fresh investments.

• International trade finance offers a flexible finance option through credit lines, which help exporters to avail of cash at any time. As a result, exporters are able to ship their products at a more competitive rate and quantity. Besides, it is apparent that trade financers provide exporters with the finances that subsequently help them to increase their business and profitability.

• If you are awaiting payment against shipments made and receive a new order, you may not have the working capital to start production immediately. By factoring in your existing receivables, you get the working capital required to kick-start the next round of production. This way, you are able to expand your market presence and business volume.