Trade finance: everything you need to know
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Trade finance makes it easier to move goods around the world and participate in international business. So whether you've recently set up a small business and want to import your first product, or you're looking to expand your business's export trade, it’s important to understand trade finance and how it can help.
Confusingly, sometimes the term 'trade finance' is used when discussing trade credit – a different product which lets you purchase new stock or goods without paying cash upfront to your supplier. Read our article on trade credit for more information on this.
Here we’ll go over the various elements of trade finance, how to use it and how to qualify for trade finance. Remember, if you need short term finance to purchase inventory or manage logistics cost, you can get approved for an iwoca Flexi-Loan in under 24 hours.
What is trade finance?
The phrase is an umbrella term, meaning it covers many different financial products that banks and companies use to make trade transactions feasible, such as issuing letters of credit, as well as lending and forfaiting – all of which we’ll discuss below.
The different parties involved in trade finance include banks, trade finance companies, importers and exporters, insurers, export credit agencies. Together, they collaborate on credit agreements that ensure relevant parties can get paid at the right time to maintain both individual cash flow and the flow of goods.
How does trade finance work
The primary goal of trade finance is to mitigate the risks associated with international trade, ensuring smooth transactions between importers and exporters. Here's a breakdown of how trade finance works:
Key types of trade finance
- A letter of credit: This is where an importer's bank makes a promise to the exporter that it will immediately make the payment once the transaction has been completed.
- A bank guarantee: When a bank acts as a guarantor in case the importer or exporter fails to fulfil the terms and conditions of the contract. This means the bank would pay a sum of money to the beneficiary.
- Factoring: Here, an exporter sells their invoices to a trade financer (the factor) at a discount. The factor then sells it on to the importer, who pays the full price for the product.
- Forfaiting: This is when an exporter sells all of their accounts to a forfaiter at a discount in exchange for cash.
- Insurance: This can be used for shipping and the delivery of goods.
- Lending: Lending lines of credit can be issued by banks or other providers to help both importers and exporters.
- Export credit: This can be supplied to exporters as working capital.
Trade finance process
The trade finance process typically involves the following steps:
- Agreement and Contract: Importers and exporters agree on the terms of the sale, including payment terms, delivery conditions, and the use of trade finance instruments like letters of credit.
- Issuance of Instruments: The importer's bank issues a letter of credit or bank guarantee, providing security to the exporter.
- Shipment and Documentation: The exporter ships the goods and provides the necessary documentation (e.g., bill of lading, invoice) to the importer's bank.
- Verification and Payment: The importer's bank verifies the documentation and releases payment to the exporter.
- Settlement: The importer repays the bank according to the agreed terms, completing the transaction.
Trade finance vs supply chain finance
Trade finance and supply chain finance are often confused, but they serve different purposes in business transactions. Here's a simple breakdown:
Trade Finance
Trade finance helps businesses manage the financial risks of international trade. It ensures that importers and exporters can safely and efficiently complete transactions.
For example, a UK business importing goods from China might use a letter of credit from its bank. This letter guarantees the Chinese supplier will be paid once the goods are shipped and all terms of the deal are met.
Supply Chain Finance
Supply chain finance improves cash flow within a business's supply chain. It allows suppliers to get paid faster based on the buyer's creditworthiness.
For instance, a large retailer can offer early payments to its suppliers through a bank. The bank pays the suppliers early, and the retailer repays the bank later, often at a lower cost due to the retailer's strong credit rating.
Is a trade finance facility right for my business?
If your business trades internationally, or is likely to in the future, then you'll need to engage with trade finance to help mitigate the risks involved. Even with a confirmed order for products, many banks won't provide loans or overdraft protection for these types of transactions, so you may need a trade loan.
Trade finance is common among businesses, with some 80 to 90 percent of world trade relying on trade finance, according to the World Trade Organisation (WTO).
There are other benefits to trade finance, too. It could help improve the efficiency of your business and boost your revenue. This is because cash flow is improved by the buyer's bank guaranteeing payment, and the importer knowing the goods will be shipped. In other words, trade finance ensures fewer delays in payments and in shipments, allowing both importers and exporters to run their businesses and plan their cash flow more efficiently.
Trade finance example
Imagine a small UK-based business, Beauty Bliss Ltd., eager to expand its product line by importing its first private label cosmetic products from a reputable supplier in South Korea. However, Beauty Bliss is concerned about the risks involved in such an international transaction, especially since they have never dealt with this supplier before.
To mitigate these risks, Beauty Bliss turns to trade finance.
- Setting the Stage: Beauty Bliss contacts their bank and explains their plan to import cosmetic products. The bank agrees to act as a third party, providing the necessary financial support to ensure a smooth transaction.
- Issuing a Letter of Credit: The bank issues a letter of credit to the South Korean supplier. This letter acts as a guarantee that the supplier will receive payment once they ship the products and meet all the terms of the contract. This gives the supplier confidence in Beauty Bliss's ability to pay.
- Providing a Bank Guarantee: To further secure the deal, the bank also provides a bank guarantee. This means that even if Beauty Bliss faces financial difficulties and cannot pay, the bank will cover the payment to the supplier. This added assurance eliminates any remaining doubts the supplier might have.
- The Transaction: With these financial instruments in place, the supplier in South Korea ships the cosmetic products to Beauty Bliss. The bank verifies the shipment and ensures that all contractual terms are met. Once everything is in order, the bank releases the payment to the supplier.
- Peace of Mind: For the supplier, this arrangement means they don't have to worry about not getting paid. For Beauty Bliss, it ensures that the products will be shipped as promised, reducing the risk of fraud or non-delivery. Both parties benefit from the security and trust established by the bank’s involvement.
Eligibility for trade finance
Trade finance is ideal for companies with strong supply chains and reliable end-buyers but lacking the working capital to go it alone. Here’s what trade financiers look for:
- Transaction details: What’s the nature of the transaction?
- Business impact: How much will this deal grow your business?
- Parties involved: Who are the other parties in the transaction?
Additional consideration include:
- Creditworthiness: Your business’s credit history and financial standing.
- Operational History: An established track record of successful operations.
- Collateral: Assets that can be used to secure the financing, if necessary.
Compliance: Adherence to international trade laws and regulations.
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