Given that nearly 90% of world trade relies on some form of trade financing (trade credit insurance, trade finance or guarantees), it’s important to understand the complexities around financing trade, the various products offered by financiers, and understanding the pitfalls, challenges and use cases for trade credit.
Trade credit financing – what is it?
Trade finance significantly increases the ability of importers and exporters to trade internationally, by providing financing and assisting to mitigate the risk of default in payments for goods or services.
There are many different types of organisations that provide trade finance, from smaller non-bank financiers (often called alternative lenders), to retails and high street banks, as well as public-backed institutions (export credit agencies, multilateral and development finance institutions).
One of the best-known instruments in relation to trade finance is the Letter of Credit (LC). An LC represents the promise of a financial institution to pay upon the seller of goods or services meeting the contract’s obligations. The seller will usually require a buyer to provide an LC before shipment (from the buyer’s bank) in return for payment once title of product ownership has passed to the buyer.
Trade Credit Products
Trade finance is the umbrella term used for the financing of goods or services, which are typically moving cross border. Here are some of the products which are used by businesses in trade credit financing:
Letters of Credit:
In today’s world, the LC is used as a standard and common practice of cross border trade. This is used especially in international trading, where buyers do not want to run the risk of payment upfront and losing deposit payments, along with suppliers wanting certainty of payment upon the provision of ordered product. Importantly, it reduces the risks when carrying out new lines of business. Using an LC as a bank instrument, will allow buyers to use their bank to play an intermediary role and provide a guarantee to the seller. Using an LC provides comfort to the seller that they will be paid by the issuing bank (of the LC) upon delivery of the goods or title passing to the purchaser (according to the conditions set out in the LC).
Trade Credit Insurance and Open Account Sales:
Many buyers demand that their suppliers will provide them with credit (time to pay) following delivery, shipping or title transfer of the product. Typically sellers provide payment terms of 30-120 days. In this case we would say that trade credit is provided to the buyer. A way to mitigate the risk of non-payment of the buyer is to use trade credit insurance. This plays a vital role if the buyer is new to the supplier or the buyer’s creditworthiness is not recognisable.
Banks and alternative lenders will also usually require trade credit insurance to be in place, prior to providing invoice discounting, receivables finance or factoring services. A trade credit insurer will usually not fully insure (100pc) of the receivables book (or a single receivable or invoice), but provide an advance of e.g. 80 or 90pc insurance cover against the receivable or invoice value.
This is a higher risk method of finance. A cash advance is usually a structure of trade finance, which is generally performed in domestic markets and on a trust basis. It will also depend on the strength of the supplier and buyer, along with demand for a certain product. Suppliers will always desire full (or a high percentage) of payment upfront (prior to shipment), but this is rare, as it places a lot of risk on the buyer. The term cash advance is used where there is partial or full payment made prior to the shipment of goods.
It includes post-dated cheques; bills of exchange or invoices that can be discounted at lower rate in order to return payment on an immediate basis. Providing an advance against the value of an invoice or contractual obligation to pay, may vary from 60pc to close to 100pc.
Long term debt including loans, commercial mortgages or overdraft facilities are generally offered both in domestic and international markets against the assets of a business owner. These loans are usually provided for a set period of time.
Revolving debt facilities that can be used to pay suppliers (utilising various instruments) for specific trades, and using the underlying products as collateral.
Leasing & Asset-Backed Finance:
This is when funds are borrowed against tangible assets, used in the operation of the business, such as property, plants and machinery. Finance is then used for the expansion of trade in relation to the business.
Advantages and disadvantages of trade credit
Advantages of Trade Credit:
1. Facilitates Growth of a Business:
The two main impediments and risk of any trading business are the ability to pay suppliers for products or delivery of services and the risk of non-payment. Therefore, trade finance is a mode of short to medium-term working capital, which provides security of the stock or service being exported or imported; with supporting products or structures that allow risk mitigation.
2. Increased Revenue & Higher Margins:
Trade finance allows borrowers to obtain a higher volume of stock orders from their end customers and benefit from economies of scale. This additional liquidity enables the business operation to benefit with higher margins, with large discounts due to bulk stock purchasing.
3. Mitigates Risk from Suppliers:
Trade finance mitigates the credit and payment risks or default risk that suppliers hold, along with having banks or financial institutions providing additional security, that larger orders can be fulfilled. Irrespective of the nature or size of a business, trade finance aims to focus on the trade cycle and underlying goods, rather than the primary borrower. Therefore, small businesses can trade larger volumes more easily as they work with a stronger credit of end customers.
4. Diversified Network of Suppliers:
Manufacturers, traders and distributors work in an increasingly global marketplace. By improving the ability of finance to flow into the system along with further risk mitigation structures, this allows business owners to diversify their supplier network. Trade finance intensifies competition as well as drives efficiency in markets and supply chains, leading to increased volumes of trade within a safer framework.
As trade finance is a form of capital that only relates to active trades of services or products, it means that an importer or exporter does not have to disturb their working capital to finance trade, so easing cash flow. This along with the increasing value or trade that a company is able to do, means that those same businesses can utilise their capital to invest in emerging or potential business enhancing techniques, strategies or machinery. This leads to faster business growth, in a structure that focuses on risk mitigation.
6. Reduced Bankruptcy Risk:
Deferral in payments from debtors and challenging creditors can have unfavourable effects on a business. Nevertheless, trade related credit facilities can ease this pressure and prevent companies from facing the difficulties that flow from these risks.
Disadvantages of Trade Finance:
1. Product Risk or Quality Disputes:
This is a risk that both suppliers and buyers attempt to mitigate. A seller usually provides contractual obligations such as warranties, agreed service levels or on-going maintenance. The buyer will also attempt to mitigate further risks around other external factors, such as negligence during production, or an unfavourable climate during shipping that may affect products. Quality is something that frequently leads to disputes between the parties, even after contracts are signed. Ways to mitigate non-performance of the contract may be by using inspectors, quality certifications or further trade finance related products, such as bonds.
2. Manufacturing Risk:
Sellers are usually required to cover the costs of any modification of a product until the buyer approves it, because it may not be possible to sell product onto end customers. It is particularly common for manufactured products to be tailor-made or have a unique specification.
3. Transportation Risk:
Along with the potential issues already discussed related to products being purchased, there is a high risk in relation to the movement of goods, from the seller to buyer destination. Transportation risk is reduced through cargo insurance and using a reliable freight forwarder or shipping company. If the buyer fails to insure the cargo in the proper way, then the insurance might not be workable if there is product damage or issues relating to the carriage of goods.
4. Currency Risk:
FX and Exchange rate uncertainty can have an adverse effect on all types of businesses and lead to a direct impact on profit margins. It is important to understand what any potential foreign currency or exchange movements will have on underlying sales agreements in which the parties entered to sell the products at a future date.
As with any debt product, trade finance comes at a cost. Therefore, it is important to understand what the profit margins are on sales or trades of a business, as trade finance is only charged on the specific trades carried out under the facility. If profit margins and costs are understood, then the financing cost can be built into the trade costing.
Trade finance facilities can sometimes appear difficult to understand for first time users of the product. Terms such as when permitted payments are possible, structure of payment, sub-limits, can mean that that agreements may sometimes be lengthy. Therefore, it is important to fully understand the facility that you are taking and the bank or alternative financier that you are working with.
In conclusion, trade credit financing is a very powerful tool when used correctly, as displayed by many of the largest multinational trading companies. It allows companies of all sizes to increase trade in a way that focuses on the underlying products being traded along with supplier and end buyer strength; this is in direct comparison to standard cash flow or basic term loans that only look at the underlying borrower, which provide limited capacity for growth.