The introduction of new finance tools has systematically improved every facet of business-to-business transactions. Nowhere has the positive impact of finance innovations been more apparent than in the arena of international trade. Thousands of companies around the world use trade finance to make international trade transactions run smoother, but this financing tool may have already been supplanted by a simpler and more intuitive way to insure global trade against political and currency fluctuations.
What Is Trade Finance?
Trade finance is a type of service that financial institutions offer to reduce the risk and uncertainty of importing items from and exporting items to foreign countries. In a trade finance agreement, the bank guarantees payment to the supplier, and it also usually gives buyers extended terms to pay off the invoice amount.
While trade finance is convenient to both importers and exporters, the main purpose of this type of finance isn’t to improve cash flow or build up reserves of working capital. Rather, companies use trade finance to make buying and selling products across national borders as close to risk-free as possible.
When Is Trade Finance Appropriate?
You might want to consider engaging in a trade financing agreement when you have to sell items to a buyer in another country. When you ship items across the Pacific Ocean, for instance, transit times can be excessive, and there’s always a significant degree of risk when you ship items over long distances.
Trade finance isn’t appropriate when you make domestic transactions. If you’re buying or selling from another person in your country, trying to get a trade finance agreement will actually make your transaction more complicated. Banks would much rather extend another type of invoice finance, such as invoice factoring or invoice discounting, that is more appropriate to your circumstances.
How Trade Finance Works
Trade finance can be a relatively labourious process involving many steps. Here’s a step-by-step breakdown of how trade finance usually works from the buyer’s point of view:
- You strike an agreement: You and your business partner in another country come to an agreement regarding the deal you’d like to make. To reduce the risk of your endeavor, you decide to pursue a trade finance agreement.
- The banks get involved: In most cases, trade finance involves both the exporter’s bank and the importer’s bank. These two financial institutions will need to communicate with each other throughout the transaction process. Your bank will arrange a letter of credit, also known as a bill of lading, which is an official document that will be issued to the exporter’s bank once the transaction is complete.
- You consider working with an export credit agency: Your bank can usually handle the logistics of a trade finance deal. However, export finance agencies are masters of trade finance, and they make the process of dealing with the import and export policies of multiple nations easier.
- You get insurance: Your export credit agency or your bank may be able to offer insurance on your order. If not, you’ll need to get insurance from a third-party provider.
- You make the order: Now that you have all your ducks in a row, you reach out to the exporter to make the order.
- The bank pays the invoice: You’ve reached an agreement with your bank, and now that you’ve made the order, your bank pays the invoice in full to the exporter’s bank in pursuance of the letter of the credit agreement. The exporter’s bank then pays the exporter.
- The supplier sells the invoice: As part of the agreement, the exporter sells the invoice for your transaction to its bank. The exporter’s bank takes over credit control for the invoice. If you default on the payment, the exporter’s bank will take it up with your bank.
- You pay the exporter’s bank: The stipulations of letters of credit require that you pay the exporter’s bank instead of the exporter. You will make the payment on or before the date the invoice matures by wiring funds through your bank to the exporter’s bank.
Real-World Trade Finance Example
Imagine that you’re an apparel designer in London. While your finance team can handle transactions within England without any trouble, you’ve found an incredible deal on fabric from Asia.
You’ve never purchased items from outside Europe before, and you aren’t sure how to proceed. You reach out to your bank, and your lending officer tells you about a variety of trade finance solutions that might be right for your circumstances. Some trade finance products are offered by independent export credit agencies, but your bank can also handle your purchase order for you.
The order costs £11,000, but you have no idea what that equates to in your supplier’s local currency. Thankfully, your bank handles foreign exchange for you, which means you won’t have to incorporate other currencies into your balance sheet.
You make the purchase with your supplier after arranging a letter of credit between your bank and your supplier’s bank. The supplier logs the invoice in its accounts receivable, and it receives payment from its bank. The supplier ships your order, and you’re able to keep your growth going steady without having to worry about payment risk and the other headaches that are inherently involved in making international trade agreements.
Benefits of Trade Finance
Trade finance has several benefits that make it a valid financial tool beyond the arena of simply improving your cash flow. Here are some of the high points of using this type of finance agreement to make sure that your international transactions run smoothly:
Reduces Payment Risk
There are a variety of reasons why an international transaction might be risky, and they aren’t all related to the special circumstances of sending goods across national boundaries. Just like any transaction involving credit, there’s always a chance that the buyer might not pay up, and there’s also the possibility that the supplier won’t ship the goods.
By involving both the exporter’s bank and the importer’s bank, a trade finance agreement sets up a dual guarantee system that ensures the transaction will run smoothly even no matter what happens. If the buyer defaults on payment, the importer’s bank will collect the funds, and if the exporter fails to ship the goods, they’ll have their bank to contend with.
In a trade finance agreement, the banks involved vet the creditworthiness of both parties, which ensures that you won’t accidentally make a deal with the wrong person. Overall, trade finance acts as a type of insurance that forces the parties involved to hold up their sides of the deal no matter what’s going on in their respective countries.
Hedges Against Political Turmoil
Understanding the dangers of political turmoil is one of the most important aspects of international trade. While mega-corporations might envision a world in which pesky anachronisms like national sovereignty no longer get in the way of free trade, the fact remains that every country has its own import and export policies, and turmoil can strike a nation at the most unexpected times.
For instance, the 2011 tsunami in Japan interrupted trade in and out of that Asian island nation in ways nobody could have anticipated. In the war-torn countries of West Africa, it’s practically impossible to know whether it will be possible to get goods in and out during a given week. Plus, trade agreements between global superpowers are constantly shifting, and the latest slew of sanctions from Washington or the newest financial edicts from Beijing can suddenly alter the flow of global trade in highly impactful ways.
When two companies enter into a trade finance agreement, they’re both protected no matter what unexpected political turmoil might erupt in either of their countries. If all else fails, the order is insured on both sides, which means that nobody will lose money.
Improves Cash Flow and Increases Earnings
Even though trade finance is specifically targeted at making trade between different countries easier, this type of financial agreement still has all the benefits of any other form of invoice finance. When cash is tight, entering into a trade finance agreement can give both parties the working capital they need to grow.
According to the time value of money theory, money you have now is more valuable than money you’ll have later because you can use your current funds to grow your business. The more your business grows, the more money you’ll make, which means that financing some working capital now can improve the value of your company in a big way in the long term.
Pros and Cons of Trade Finance
To bring it all home, here are some of the top benefits and detractors of engaging in an international trade finance agreement:
- Reduces the risk of transactions with overseas exporters or importers.
- Improves cash flow for both importers and exporters.
- Can involve four or even five separate parties, which can make things complicated.
- Sometimes involves labourious application processes.
- Since two banks are involved, the overall administrative charges are greater than is usually the case in invoice finance agreements.
Trade Finance and CreditDigital
CreditDigital streamlines the process of doing business with domestic companies while vastly reducing the risk of transactions. Trade finance is an excellent service, and it protects both importers and exporters from the risks of trade. However, this type of financial agreement is outdated, and our intuitive online platform serves as a next-generation alternative to the irritatingly slow and involved process of securing trade finance.
Here at CreditDigital, whether you’re a buyer or a supplier, we take on full credit control for the invoices you receive or generate, so you won’t ever have to judge the creditworthiness of a potential business partner on your own again.
For buyers, we offer the same extended terms that can make trade finance so attractive. In fact, we go above and beyond the terms of most trade finance agreements to give you up to 12 months to make payment in full. Plus, we also offer 0% interest options that will keep your costs down.
For suppliers, we give you 100% of your invoice value up front as soon as your buyer agrees to a payment plan. This feature allows you to keep running your business just like you would if you’d received payment directly from the buyer. While trade finance agreements can be complicated, we make it easy for you to get your money with a simple and straightforward application process.
One of CreditDigital’s best attributes is how easy it is to access our platform. Whenever you want to perform a new transaction with an overseas client, all you need to do is open our mobile app or go to our desktop interface and complete a few simple steps. With CreditDigital, you can say goodbye to unreasonably long wait times and multiple phone calls just to make a simple transaction. From small purchases to deals that could change your business forever, CreditDigital is standing by to make the process of offering or receiving credit easy.
To help you firm up your knowledge of the world of trade finance, here are a few basic definitions of some of the terms you might come across in your research:
Invoice finance is any financial agreement in which a supplier agrees to sell its invoices to a bank in exchange for cash up front. Since trade finance involves the sale of invoices to a bank, it is a type of invoice finance. Trade finance is one of the most complicated versions of invoice finance, and some examples of simpler options include invoice discounting and invoice factoring.
Supply Chain Finance
Supply chain finance (SCF), also called reverse factoring, is essentially the same thing as trade finance. However, supply chain finance agreements are made between two entities doing business in the same country. As such, SCF agreements don’t involve multiple banks, costly insurance, or any of the other hurdles that are traditionally associated with trade finance.
A documentary collection is when an exporter tasks its bank with collecting payment for an invoice from a buyer. Most types of trade finance are different from the documentary collection because they involve both the buyer’s bank and the supplier’s bank. Documentary collection can occur in both domestic and international transactions.