What is trade finance?
Updated: Mar 1
Introduction to Trade Finance: How it Works for Your Business
Trade finance helps Australian businesses facilitate import and export transactions in international trade. It makes it easier to buy and sell goods, bridge the cash flow gaps, and capitalise on business opportunities in the domestic and overseas markets. Business owners, who are planning to import goods or looking to expand, may want to know how trade finance can help grow their businesses in the long run.
As of October 2022, the Australian trade balance is $147.93 billion with companies exporting goods and services worth $593.80 billion and importing worth $445.87 billion. It has a diverse group of trading partners operating in different political and economic environments with the likes of China, Japan, South Korea, India, and the United States.
By Definition: What is trade finance?
Trade finance covers a range of financial products designed to help businesses access to trade to buy and sell goods and services while mitigating the risks involved in such transactions. In simple terms, it involves two parties - the exporter, who requires payment for goods and services, and the importer, who wants to make sure they are paying for the right goods and services.
When financing is required by exporters and financers, trade finance is utilised to assist them with the trade cycle funding gap and mitigate potential risks. This often requires:
✔️ Control of the use of funds, goods and services, and the source of repayment
✔️ Visibility and monitoring over the trade cycle through the transaction
✔️ Security over the goods and receivables
Trade finance also helps settle their conflicting needs when the exporter needs to mitigate the importer's payment risk while the importer needs to mitigate the exporter's supply risk. It also acts as a third-party conduit that will remove both payment and supply risks while also providing the exporter with accelerated receivables and the importer with extended credit. Traditional providers include suppliers, banks, syndicates, trade financing houses, and buyers.
Trade finance is a large industry that usually covers a wide variety of sectors. The usual users of trade finance include producers, manufacturers, traders, and exporters.
Whenever international trade occurs across borders, especially with businesses that are not familiar with one another, there are risks involved.
What are these risks?
✔️ Payment Risk - Will the exporter get paid in full and on time? Will the importer get the goods and services they asked for?
✔️ Country Risk - There are a lot of risks involved when doing business in another country like unfavourable exchange rates, political instability, economic downturn, and absence of legal structures.
✔️ Corporate Risk - There are also risks involved with dealing with a certain company like bad credit ratings and a history of non-payment and default.
In order to mitigate these types of risks, banks and other financial institutions step in to provide trade finance products.
How it Works
The main purpose of trade finance is to increase business liquidity and improve risk management to facilitate trade through a third party in every transaction between the importer (buyer) and the exporter (seller). Such risks occur in any trade transaction and resolution of these can be difficult and time-consuming especially in foreign markets involving different cultures and regulatory oversight.
A. Parties Involved
Just like any market where the law of supply and demand applies when two parties facilitate the exchange of goods and services, trade finance operates in such a concept as well. Both importer and exporter are looking to manage their interests and needs with one looking for funds to finance its business operations while the other is looking to invest its excessive liquidity for substantial returns.
1. Financial Institutions
These companies are licensed to provide much-needed funds for businesses in need of financing through a variety of financial products like investments, loans, and deposits. There is a regulatory body that oversees trade finance activities to prevent illegal money lending and laundering practices.
They normally perform due diligence on all parties involved. An onboarding process is conducted to ensure all parties comply with the legal requirements.
2. Importer (Buyer)
The importer is the one purchasing goods and services from the exporter so by definition, they are the debtor that owes from the supplier. That means they are legally bound to pay the debt with their counterparty.
3. Exporter (Seller)
The exporter is the one producing the goods and services that the importer wants. They engage in international trade activities by selling these overseas.
Since they have their own rights on the invoice payments, the importer will have to repay the debt in due time. In trade finance, they are the pillar of the origination stage wherein "origination" is where the invoices, receivables, and other credit rights come from.
Investors can be in the form of hedge funds, high net-worth individuals, or banks looking to invest their excess liquidity in alternative sources of yield. They could use trade finance instruments with 30- to 90-day expiry by rolling the position a few times so they could pick a better yield than letting the funds sit in the current account.
5. Financial Intermediaries
Insurance brokers assist in the underwriting of the contract between trading parties as some expensive goods and services may need insurance coverage.
There are agents that help small- and medium-sized businesses in Australia access funding options from financing institutions. Some help connect clients with excess liquidity to financial institutes. It is important to know that they don't have the licence to operate as lending agents. Instead, they rely on their extensive portfolio of high net-worth individuals, family offices, and hedge funds to generate revenues.
Finally, the ship and freight brokers have a very important role in the supply chain as they move raw materials and goods across different markets and countries. They often facilitate important trade finance and international commercial activities.
b. Trade Mechanism
In this arrangement, the exporter can maintain good working capital through invoice financing and payment guarantee while the importer can finance the purchase of goods and services and ensure these are shipped before the payment goes through. Unlike traditional business loans or overdrafts, trade financing can plug cash flow gaps and manage risks in domestic and international trade.
We can simplify the steps in doing trade finance into the following:
✔️ The importer's bank provides a Letter of Credit to the exporter.
✔️ It will serve as payment with the presentation of certain documents such as the Bill of Lading.
✔️ A loan can be made by the exporter bank based on the terms of the export contract.
It is interesting to note that banks only deal with documents and not the actual goods and services referred to in the document.
Types of Trade Finance
According to the World Trade Organization, the global economy relies up to 90% on trade finance through trade credit and short-term insurance. There are a variety of trade finance products that make it easier for importers and exporters to make international transactions.
a. Open Account
It is the most common way of structuring a trade finance agreement as the importer pays for goods after they receive them. This way, it protects the importer from the risk of payment for goods that don't meet required standards. However, it doesn't protect the exporter. Open accounts are recommended for trusted or low-risk trading.
The risks are mitigated through export credit insurance, factoring, or supply chain finance. Factoring is a receivables financing where exporters sell their accounts receivable to a factor, which takes on the responsibility for outstanding payments. Unlike factoring, supply chain finance is initiated by the importer rather than the exporter wherein the finance cost is based on the former's credit rating thereby giving the latter more favourable rates.
b. Letters of Credit
Issued by the bank, this is a widely used instrument that provides protection to international trading activities depending on personal purpose or business needs.
The common types of letters of credit include:
✔️ Commercial - Also known as import-export credit, the exporter's bank will only release the funds after conditions are complied with.
✔️ Standby - Designed for payment or compensation guarantee just in case certain terms or conditions fail to meet.
✔️ Transferable - Allows the beneficiary to transfer either part or full payment to another exporter.
✔️ Back-to-Back - Connects both importer and exporter through intermediaries.
✔️ Revolving - Allows businesses to do multiple different transactions on one letter of credit until it expires.
Unlike open accounts, payment in advance allows the importer to pay the exporter before the goods and services have been received. This method protects the exporter from the risk of non-payment or default but it does not protect the importer from the risk that goods will not be received on time and in good condition.
d. Payment Against Documents
Just like a letter of credit, this financing method is less expensive as it involves presenting the documents to the importer's bank before the exporter is paid. The importer has the option to reject the goods received.
e. Export Finance
Specifically designed to help exporters maintain proper cash flow and boost sales cycles, this type of financing uses accounts receivables as collateral to access a line of credit. In this way, the business doesn't have to wait for the overseas payment to clear as they start producing or manufacturing goods.
f. Import Finance
Unlike export finance, this type of financing is suited for businesses that purchase finished goods from domestic or international suppliers. There is an invoice finance facility that provides a line of credit for up to 180 days thereby helping businesses fund the purchase of goods and repay the amount owed using outstanding customer invoices.
Benefits of Trade Finance
Whatever the case, securing the funds is necessary for the growth and future expansion of any business and the best way to achieve it is through effective management of cash flow and working capital.
With trade finance, you can fully unlock capital from your existing stock or receivables based on your trade cycles. The key to success is the reduction of payment gaps and other risks. Once that's taken care of, you can offer more competitive terms to your suppliers and customers thereby increasing your competitive edge and further reducing payment and other business risks.
a. Risk Reduction
Global trade is not a smooth sailing operation as there are a lot of variables that would affect any trade transaction, big or small. Reconciling the divergent needs and requirements between exporters and importers is already challenging in itself.
Providing guarantees like a letter of credit further ease any transaction between parties. It helps build trust thereby ensuring both parties take responsibility to ensure that the trade goes through smoothly.
b. Increase Liquidity
With a funding facility in place, trade finance would increase liquidity and fill out cash flow gaps so you can pay existing overheads knowing that you have the financial support to take on new orders. Furthermore, you can extend payment terms to customers or secure bulk buy and early payment discounts from suppliers.
c. Increase Revenue and Earnings
Trade finance will help you increase revenue and earnings through export financing and help from the state or federal trade finance agencies. Not only that, but it can also fuel growth even in an economic downturn brought about by the COVID-19 pandemic.
Any Australian business needs all the help it can get, and trade financing provides a lifeline in these challenging and difficult times. Falling behind on payments or losing key customers or suppliers could have a serious impact on your business's long-term financial viability.
At the end of the day, every business deserves the opportunity to grow and thrive by gaining access to a whole range of flexible solutions including a revolving line of credit that would help them compete in global markets.
Want to get your business funded fast? Funding Link is committed to providing small to large businesses with flexible and fast funding solutions. Find out what your options are. Apply here now!