What is Trade Finance? | Methods & Types explained in detail

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 available in India

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 available in India 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

What are 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.

Who provides term loans?

Term Loans are sanctioned for projected loans. They are basically provided by banks and financial institutions. Term loans are for a specific period of time and the repayment is done either in fixed rate or floating interest rate.

Benefit of term loans:

A business can have a large amount of money for urgent needs. Monthly costs can become affordable in terms of purchase of items and assets. They can easily be converted into equity and other sources at the conditions, laid by financial institutions.

Working Capital Limits like Overdraft or Cash Credit (CC)

What are working capital limits?

Different types of credit meant for financing foreign trade are overdraft and cash credit, which can help both importers and exporters to apply for cash as and when they need against it, as long as the credit 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.

How to use working capital limits?

Businesses are supposed to borrow small amounts from the line of credit 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.

Their benefit:

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

Letter of Credit

How letter of credit works in India?

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.

Who provides Letter of Credit?

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

LOC - Beneficial for which party:

The beneficiary is the party which gets the payment under a letter of credit. Once the beneficiary gives all the necessary documents with the bank in accordance with the terms and conditions, he becomes the main party under letter of credit.

Invoice Factoring or Invoice Discounting

What is invoice factoring?

You can approach your bank, a financial institution or a trade finance company 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 Discounting 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.

How it works?

A business client makes an agreement with a factoring company, where after an agreement the company handles the clients sales and credit for a period of time. Factoring companies provide goods & service to customers who have credit worth & then submit correct invoices. Once the procedure is completed the company will then pay you the remaining balance, taking their commission in account.

Benefits of Invoice Factoring:

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.

Export Credit

Export Credit - Offering:

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 will be adjusted and the loan will be closed against that order.

Importance of Export Credit:

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

Insurance

Trade 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.

Insurance Service Providers:

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.

Benefits of trade insurance:

It increases profits and reduces risk factors in terms of foreseen conditions. Not only does it boost sales for the business, but also offers favourable credit terms to customers. Banks will be in favor of businesses who have trade insurance and will offer them more favourable lending terms, in concern of their accounts receivable.

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.

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.