Trade Financing In International Trade
Simply put, trade financing is the answer to the question “Who’s going to pay for the goods and shipping?”. No business wants to pay excessive costs upfront, especially when manufacturing, high value shipments. And it’s a rare case where the supplier wants to take a gamble on whether they will receive payment from a new and untrusted customer a few months down the line.
Trade financing is when an importer gets financing to pay a supplier, while paying back the financer after selling their goods. This allows for more inventory and higher profits in situations where there is no pre-existing supplier/import relationship. Financing terms typically involve a monthly payout or a payout at a fixed interval and can range from 5%-10% of the value of the loan.
The Trade Finance Guide
In this article, we’ll take a quick look at how trade-financing helps importers manage business cashflow while ensuring suppliers that the receive guaranteed payments when they need them.
We’ll touch on some key terms you’ll need to know when financing imports, discuss the costs associated with trade financing, and describe the steps to take to actually secure financing for your goods.
How does Trade Financing work?
Imagine Michael, a fairly advanced importer who is running brisk global trade importing horse-shaped calculators for equestrian equations. If he has $20,000 of free cash, he’ll be able to afford, say, 1000 units. Factor in global freight costs, customs, fulfilment costs, fees for Amazon and other associated costs, and suddenly Michael is down to 800 units…even though he knows there’s brisk demand.
Using trade financing, Michael can pay the deposit for his goods and have a third-party secure payment to release the goods from the supplier. While he’ll end up paying additional fees on top of that, it still means that he can source and import 2,000 units, earn more profit, and then pay off the trade financing company.
Trade Finance Explained
Although there are numerous ways trade can be financed, they all involve a financial agreement made between exporters, importers and their banks. This allows the buyers and sellers to reduce risk and receive cash when they need it, taking advantage of the bank’s willingness to provide capital upfront. If you’re a potential importer or exporter, this makes engaging in global trade easier, more streamlined and allows you to plan for the future with certainty.
Key Trade Financing Terms
Importer: Typically the buyer of goods looking to secure financing for importing. This is generally the person on the receiving end of a shipment (ie consignee).
Supplier: The person manufacturing or selling the goods is on the supply side. In some cases, like if they are shipping under the EXW incoterm, this person would also be responsible for shipping.
Financing: The capital, the money, the dollar. Call it what you want. This is the cash which directly funds the production, shipping and other immediate costs.
Letter of Credit: An important document in trade financing. A letter issued by the buyer’s bank, which guarantees the seller they will receive payment later.
Forfaiting: Selling your receivable to a bank (at a discount) for immediate payment, passing the burden of collection onto them. The party who buys the receivable (the bank) is known as the forfaiter.
Why Is Trade Financing Important?
The question of who pays upfront is important.
The case for trade financing? Call it the time-value advantage of paying later or cash flow consideration – it’s effectively the principle that a bird in the hand is worth two in the bush. By delaying the payment, the importer can effectively purchase more. There are no free rides though. Importers will pay interest on the financing and need to pay off the financing whether the goods sell or not. Finally, since it’s their money at risk, financing organizations will do significant due diligence, which can take days to weeks for newer companies.
Why trade finance global imports?
While it’s fine for either side to extend terms directly to each other, it carries a risk, and requires placing trust in an overseas party, who you may never have dealt with before. And the risk naturally increases with more valuable shipments. To mitigate against this risk, trade financing can be brought into play, where the importer and the exporter come to an agreement to offset this risk to a bank (or two). This can involve the supplier “selling” the invoice to a financing organization, which then assumes the risk, pays the exporter, and then collects from the buyer, or the buyer bringing their own trade financing solution to the table to pay the vendor.
So how does trade financing actually work?
When importing from overseas, a buyer typically pays the provider a portion of the goods cost upfront as a deposit (usually about one third), with the rest paid before it ships. This is typically when whoever is trade financing (the bank) will pay. The problem in this scenario, if you are a buyer, is the challenge of providing capital upfront with no guarantees of successful shipment.
Depending on the financing terms, the buyer then either pays a monthly sum of interest to the lender. In some cases, this can be reduced to a lump sum payment at the end, with the interest layered on there. Of course, businesses with higher inventory turn-over will benefit more from the extra 30-120 days secured through financing.
How to choose a trade financing partner
Today, larger banks as well as a bevy of financing start-ups are available for importers. As with any financial product, best to shop around and do your own due diligence or ask for recommendations in your network. Everyone from global giants like Wells Fargo and HSBC to small scale financial institutions are likely to offer their own contribution to the world of trade finance. The easiest way to find out more might be to phone your bank directly and ask to speak to the trade finance team.
In terms of specific considerations, you might want to pay attention to:
- The approval process: how long is the approval process? What documents are required?
- Eligibility: does the lender have specific eligibility requirements, like how long the company has been operational, minimum sales volumes, geographic location and more?
- What are the payment terms? When do you need to pay back the lender? What are the interest rates? What are the penalties for late payments?
- Do they pay the down payment? Or only the second, pre-shipment installment?
- Are there securities required? Do you need to provide personal guarantees?
Some other key terms
Letters of Credit
If you are an importer and are not well known to the company selling to you, then that company may ask you to open a Letter of Credit to secure your payment to them. A letter of credit is a guarantee issued by your bank. This is the peace of mind that the seller needs to ensure their payment. It’s easier to trust a reputable bank, rather than a small business they have not yet dealt with. By issuing a Letter of Credit on your behalf, your bank assumes the payment risk, giving an exporter a firm commitment that they will receive their cash.
In some cases, the exporter needs working capital for production. Coming back to our previous scenario, think for a moment about Linda, the producer and exporter of the wonderful horse-shaped calculator. Imagine she has received a special order for 10,000 racehorse-themed calculators for a sizeable stallion start-up. She would love to take this order, but her current account is running dry. She realizes she would need $25,000 upfront to take this order. The start-up doesn’t have the funds to front this cash either. But instead of sacrificing an otherwise profitable venture, both parties can turn to trade financing.This is referred to as per-shipment-finance.
Once the exporter has a confirmed order from a buyer (sometimes backed by a Letter of Credit from the importer’s bank), they can go to their own bank and request advance payment. The Letter of Credit is Linda’s bank’s guarantee that there is indeed an order and an agreement for payment is in place. In this case, the working capital may be required to fund wages, production costs, buy raw materials and any other costs related to the production of the sale. Banks may often agree to fund up to 80% of the agreed payment upfront.
Another concept similar to the above, in all but timing. A financier can advance the payment once an exporter has shipped goods, so they have sufficient liquidity between shipping the goods and receiving the payment. Post-shipment finance can operate in a number of ways: through a Letter of Credit, a loan via an account’s receivables document, or via invoice factoring or Receivables Discounting.
So now you’ve learned why you might want to avail of trade financing, you know a few of the pitfalls to look out for (and the costs involved), and you’re aware of the benefits trade financing can bring to all parties involved. You know when it might make sense for you to call up your bank and ask to speak to their trade finance team. Let’s summarize:
Maybe you want to import goods from an overseas exporter. They have not dealt with you before so need assurance that they will receive payment, as one missed payment could be disastrous. So common practice is that the exporter requests a letter of credit from the buyer’s bank, a guarantee on the payment.
With the letter of credit in payment in hand, the exporter can now approach their own bank, and request a forward of the payment on the basis that a guarantee has been provided. One bank places trust in the other’s word (the favor may be returned tomorrow) and issues finance to help them meet their working capital needs. The buyer’s and seller’s bank have engaged in trade financing for their customers.
What can I do next?
So, if you’re looking to engage in a profitable venture overseas, but the risk and uncertainty is holding you back, pick up the phone and ask your bank if they offer trade financing. Most banks have expert teams who can answer your questions. It might be the most profitable call you’ll ever make. Or head right here to see what Freightos’ preferred trade financing solution is, with competitive terms, rapid approval, and no monthly payouts.