Trade Finance: Accelerating International Trade Via a Risk-Free Mechanism
International trading involves a certain degree of risk. To mitigate any kind of risk faced by the importer or exporter, companies use trade finance as medium. Trade finance is an umbrella term for all financial products that banks and companies make use of to facilitate trading.
Continue reading to know more about trade finance and how it works.
What is Trade Finance?
Any financial product provided for the purpose of conducting domestic and/or international trade between a buyer and a seller is referred to as trade finance. Banks and financial institutions can provide such financing, allowing the transaction to take place.
Trade Finance in banking may provide the buyer with additional protection and the seller with quicker access to the funds generated by the transaction.
How does Trade Finance Work?
The purpose of trade finance is the addition of a third party to transactions resulting in the elimination of payment and supply risks. Trade finance provides payment to the exporter in accordance with the agreement, while the importer may be extended credit to fulfil the trade order.
Trade financing is not the same as traditional financing or credit issuance. While general financing is used to manage solvency or liquidity, trade financing does not always indicate a buyer’s lack of funds or liquidity. Instead, it can be utilised to protect against the unique inherent risks of international trade. For example, political instability, currency fluctuations, nonpayment issues, or the creditworthiness of one of the parties involved.
Also Read: What Is Scalping Trading and How Does Scalping Trading Work?
Purpose of Trade Finance
Trade finance stands for the tools, techniques, and instruments that facilitate trade while also protecting buyers and sellers from trade-related risks. Trade finance aims to make it easier for businesses to do business with one another. It also contributes to lowering the risks associated with global trade for both buyers and sellers.
Who can Provide Trade Finance?
Trade finance can be provided by the following trade finance companies:
- Banks
- Companies that provide trade finance
- Traders and Exporters
- Insurers
- Service Providers
- Export Credit Agencies
Who can use Trade Finance?
Any company, whether it’s a small business importing products/materials from overseas, or a multinational corporation doing annual imports or exports of a large stock of inventory around the world.
The goal is to get money in and out of the tunnel as quickly as possible, without having to worry about complications like volatile exchange rates or cash flow issues jeopardising your trading process.
Why do Companies need Trade Financing?
Trade finance is important for companies for the following reasons:
- Provides business opportunities for small and medium scale enterprises
- Provides chances to extend credit in select conditions
- Facilitates companies to receive cash payments
- Reduces payment risks for small industries
- Provides opportunities for financial scalability for companies
- Cash flow is increased with the help of trade finance
- In case of international trade finance, SMEs can gain market experience in international scenarios.
- Export and import trade finance ensures guaranteed payments
- Facilitates paperless and streamlined trading for companies
What are the Trade Finance Products?
There are several Trade finance products. They are listed as follows:
1. Letter Of Credit
Simply put, a letter of credit is a payment pledge issued by a bank on behalf of the importing client. Essentially, it is an undertaking by the bank to pay the exporter the money within a certain time frame and under the terms and conditions agreed upon.
It enables sellers and buyers to mitigate some of the inherent risks of international trade, such as currency fluctuations, nonpayment, and economic instability.
The following are the most common types of Letters of Credit:
- Commercial Letter of Credit: also known as the import/export credit. If the conditions are met, a confirming bank from the exporter’s side releases the funds.
- Standby Letter of Credit: It is intended to guarantee payment/compensation in the event that certain terms or conditions are not met.
- Transferable Letter of Credit: This type of letter of credit allows the beneficiary to transfer part or all of the payment to another supplier.
- Back-to-Back Letters of Credit: allows intermediaries to connect importers and exporters.
- Revolving Letters of Credit: These allow businesses to conduct multiple transactions on a single LC until it expires.
2. Finance for Purchase Orders (PO)
Purchase Order (PO) financing is intended for SMEs that are experiencing inefficiency in their cash flow. This is part of the trade finance pre-shipment solutions.
To put it simply, it provides capital to pay suppliers with the verified purchase order in order to ensure smooth cash flow. It enables businesses to accept a large volume of orders while adjusting the loan basis to meet their specific requirements.
This is especially true for SMEs, which frequently receive a large volume of orders but lack the necessary working capital to process them. That is exactly what it does. Even if the volume of orders decreases, there are no ties, so you can stop using it whenever you want.
3. Finance for the Supply Chain
Supply Chain Finance (SCF) is for sellers, buyers, and financial institutions. Its primary goal is to improve payment terms and make your cash flow more flexible during the supply chain process. Payment terms, including an extended payment schedule, would be negotiated by the buyer. At the same time, the seller can receive immediate payment while quickly unloading the products.
Supply chain finance is not a loan in the traditional sense. In fact, it is a cash flow solution based on technology that reduces financial costs. It primarily accomplishes the following tasks:
- Track invoice approval and settlement processes
- Automate transactions
The benefit of this is that it frees up some of your working capital while you wait for the shipment. As a result, your money will not become trapped in the supply chain, making your cash flow more flexible.
Eligibility to Avail of Trade Finance Products
Globally, the eligibility criteria for obtaining Trade finance products remain largely unchanged. Because it is a loan, most of the regulations and requirements of traditional trade finance apply. Additional criteria may apply depending on the bank, but on average, the following conditions, if met, qualify a customer to obtain a trade loan without difficulty:
- Age – As with any loan, the interested customer must be of legal voting age or older and be able to conduct business in partnership or sole proprietorship.
- Business Age – The minimum number of years required for a business to be operational varies by bank, but can range from 2 to 4 years.
Also Read: Personal Finance: Income, Investment And Expenditure
Benefits of Trade Finance
The following are the benefits of Trade finance products:
- This type of financing scheme enables businesses to conduct international transactions with ease.
- Using this scheme, business owners can pay their clients upfront, regardless of their geographical location, without spending any money right now.
- Borrowers can repay the debt to the relevant financing organisation at a later date within the time frame specified.
- Businesses can pay their suppliers in their local currency to reduce any currency risk that may arise later.
- The most significant advantage of this scheme is that it ensures security on payments made to a supplier and helps the borrower’s relationship with them.
- The finances under this scheme are usually covered by an insurance policy.
- This financing scheme helps improve a company’s cash flow by providing the necessary credit while assisting it in managing its trade cycles without affecting business relationships.
- The borrower can concentrate on its growth activities by utilising trade financing.
Final Word
Trade financing is a difficult term to define because there are many different types of Trade Finance in banking, but it can be understood that it is a major facilitator in the growth of global trade by reducing the many risks that come with doing cross-border deals.
Trade financing is a difficult term to define because there are many different types of Trade Finance in banking, but it can be understood that it is a major facilitator in the growth of global trade by reducing the many risks that come with doing cross-border deals.
To succeed in the trading market, any business must take advantage of the many solutions trade financing provides, establishing connections and relationships with the parties involved and sustaining revenue.
FAQs on Trade Finance
Ans: The first step in purchasing goods or stocks is to secure the funds required for the expansion of your business. And the best way to do so is to use a tool that assists you in managing your cash flow and working capital.
Trade finance’s role is to eliminate the risks involved with payment and supply for both exporters and importers, ensuring that every aspect of the trade is secure.
Ans: Letters of Credit (LoC), Trade Crediting and Political Risk Assurance, Invoice Discounting, Supply Chain Financing, Documentary Collections (DC) or Receivables Financing (SCF).
Ans: It can help your company in the following ways:
•The benefit of trade finance is that it can unlock capital from your company’s existing stock or receivables based on your company’s trade cycles. The main point is to close any payment gaps
•It can allow you to offer more competitive terms to both your suppliers and customers, increasing your competitive edge while reducing other risks such as payment, country, or corporate risks.
•By closing these payment gaps, you can significantly reduce exchange rate risks while also increasing the efficiency and flow of your trading cycle.
•Although invoice discounting is not strictly a trade financing activity, some trade financing institutions do use this product.
Ans: Trade finance reduces payment risks by clarifying payment modes and periods to importers and exporters through bank letters of credit.
Disclaimer
This article is solely for educational purposes. Navi doesn't take any responsibility for the information or claims made in the blog.
