What is trade finance?
Trade or export
finance concerns international and national trade transactions – when a buyer purchases goods or services from a seller, the financial activities involved come under the umbrella term ‘trade finance’.
Trade financing includes:
- Lending facilities
- Issuing Letters of Credit (LCs)
- Export factoring (companies receive funds against invoices or accounts receivable)
- Forfaiting (purchasing the receivables or traded goods from an exporter)
- Export credits (to reduce risks to funders when providing trade or supply chain finance)
- Insurance (during delivery and shipping, also covers currency risk and exposure)
Why is trade financing important?
Trade financing (also known as supply chain and export finance) is a huge driver of economic development and helps maintain the flow of credit in supply chains. It is predicted that 80-90% of global trade is reliant on trade and supply chain finance, and is estimated to be worth around USD $10 trillion a year.
As a result of the global economic crisis in 2008, export markets reduced in size by around 40-50%, SMEs being the hardest hit. As a result, lending decreased as investor’s appetite for risk decreased, and banks had to reduce the sizes of their loan books.
Who benefits from trade finance?
Export finance has many beneficiaries: developing countries, governments, small and medium enterprises. SMEs are engines for economic growth and development, accounting for around 99% of businesses, 50% of employment and driving around 30% of private sector revenue in the UK.
In relation to export finance and the supply chain, many SMEs play a large role in the running of multinational corporations and larger companies. SMEs require access to finance to fulfill larger contracts, import goods from overseas and create wealth, jobs and develop economies.
Challenges for SMEs in accessing trade or export finance
From the banks perspective, as the regulation burden (i.e., Basel III) has become heavier, SMEs often don’t fulfil certain criteria for banks to justify lending to. As lending money has an associated transaction cost, it is more costly to assess and monitor loans to a smaller, riskier company where profit is less certain, relative to a larger, more profitable and stable business.
Banks will often ask for the following from any company when filling out an application for any type of business finance:
- Audited financial statements
- Full business plans
- Financial forecasts
- Credit reports
- Details and references of the directors
- Information on assets and liabilities
As well as the cost of lending to SMEs being less profitable for banks, there is a much higher default risk and chance of bankruptcies with SMEs in comparison to larger firms. The other challenge banks have in lending to SMEs is the lack of security and collateral an SME can provide.
SMEs also face challenges in accessing finance from banks. In a recent survey by the British Business Bank, 46 percent of SMEs were looking to grow in the next 6 months, yet awareness of types of finance available and finding sources of finance (especially after being rejected from a bank) are major concerns amongst SMEs. The perceived high cost of borrowing, lengthy procedures for securing a loan and also the amount of paperwork and documentation required is often off-putting and cumbersome to SMEs.
Benefits of trade financing
Most businesses require financing at some stage, particularly those in the international export or global supply chain trade where capital costs are high and profitability is greater when order volumes are high.
As well as economic benefits (job and wealth creation), individual companies benefit from export finance as it generally increases productivity, profitability and growth. Below is a summary of the benefits an SME can see from external financing, in particular, trade and export finance:
Trade and Export Finance Benefits
- Allows growth of an SME – More working capital and better cash flow management allows business owners to keep in control of the day-to-day running costs of the business whilst growing and fulfilling larger orders that ordinarily wouldn’t be possible.
- Higher profit margins – A finance facility can allow an SME to buy in bulk or volume, up front (at reduced costs) and strengthens the relationship between buyers and sellers. This can be an opportunity to increase profit margins and EBITDA.
- Greater efficiency and productivity – Working with other international players allows business owners to diversify their supplier network which increases competition and drives efficiency in markets and supply chains.
- Reduces bankruptcy risks – Late payments from debtors, bad debts, excess stock and demanding creditors can quickly cause the crippling of an SME which is reliant on effective cash management in order to stay alive. External financing or revolving credit facilities can ease this pressure and prevent an SME from facing these risks.
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