The availability of finance is essential for the smooth working of any trading system.
Businesses that are heavily reliant on the global supply chain need a comfortable level of liquidity to meet a whole range of cash needs.
The sad reality for most businesses is that achieving a desired level of liquidity is not easy — considering how a large chunk of business capital is tied up in its inventory or worse, locked up in a long string of invoices that are yet to be paid. Let’s not forget the cash crunch that businesses big and small are battling courtesy of the adverse effects of the pandemic.
For those participating in global supply chains, securing traditional financing may be hard and at times it may not even be enough to meet the growing needs of businesses that are into the import-export business.
This is where trade financing comes into the picture. Trade financing solutions are a catalyst for business growth today. Over the years, the trade finance sector has undergone considerable development. Recent policy updates like amendments to the Factoring Regulation Act, 2011 and rules to widen the scope of trade credit insurance, are promising to further strengthen India’s trade finance sector. From big corporates to MSMEs, trade finance is an important form of funding.
Trade finance explained
Trade finance is often referred to as the lubricant that is oiling the engines of international trade.
In simple terms, trade finance is an umbrella term that is given to a wide range of financial products and instruments that are offered to banks and companies. Trade financing solutions facilitate import and export activities and ensure that international trade transactions are carried out hassle-free.
So how does trade finance work?
The thing with international trade is that only a small part is paid in cash as advance. Importers usually prefer to make the payment only on receipt of the shipment, to verify the physical integrity of the merchandise. Whereas exporters prefer to be paid once the shipment has been dispatched.
Considering the difference between the time the exporter needs to be paid and the importer will make the payment, a credit or a guarantee of payment is needed to bridge the gap.
To facilitate the payments for the merchandise or service, on terms that are acceptable to both the exporter and the importer — trade financing solutions are leveraged to offer the credit, payment guarantee, or insurance that is needed.
Trade finance brings in a third-party financier into a trade transaction. The financier puts in the money to pay the supplier and lets the buyer repay the amount with extended credit terms. This way trade finance mitigates cash flow imbalance and removes the risk that is involved in supply and payment.
The parties that are involved in trade finance can include:
- Importers and exporters
- Trade finance companies
- Insurance companies
- Credit agencies involved in the export business
- Service providers
How is trade finance different from conventional financing?
Trade finance varies a lot from traditional financing or credit issuance.
Any form of general financing is usually availed in cases of a cash crunch or to manage liquidity and solvency. Utilizing trade financing solutions need not indicate a lack of funds on the buyer’s end.
Trade financing solutions are largely used to protect players within the global supply chain ecosystem, from the inherent risks of international trade. From issues of non-payment or creditworthiness of any of the parties involved to volatile currency rates and political instability, international trade is exposed to a myriad of risks.
Types of Trade Financing Products and Solutions
There are a plethora of products and solutions that fall under the ambit of trade finance. Let’s look at the most common type of trade finance products and solutions.
- Letter of credit:
The Letter of Credit or LOC is one of the most popularly used trade finance instruments. It serves as a pledge for making the payment and is issued by the bank on behalf of the importer. The buyer or the importer provides a payment guarantee to the seller or the exporter for the goods that are shipped.
- Supply chain finance
Supply chain finance is not a loan but it’s a cash flow solution that helps to unlock the funds that are tied up in supply chain tiers. The importer can negotiate for an extended payment term, whereas the exporter can get paid as they unload the goods. This solution makes cash flow more flexible and ensures that the money doesn’t get stuck in the supply chain process.
- Purchase order financing
Purchase order or PO financing is a pre-shipment financing solution. In this case, the financial institution advances a percentage (usually between 30% to 70%) of the purchase order notional amount to pay the supplier of the goods.
- Invoice discounting
Invoice discounting is the process by which the seller transfers the ownership of the invoice to the financial institution for faster liquidation — in which case, the debtor will then owe the money to the financial institution and not the seller. The bank or the financial institution will advance a certain percentage of the invoice to the seller. The remaining amount is paid on the maturity of the invoice, after accounting for mutually agreed-upon fees.
5 benefits of trade finance for businesses
You may be a small business importing raw materials from overseas or a large corporation that is exporting and importing large stock of inventory — regardless of where your business fits in the supply chain process, trade financing could be extremely beneficial to you.
The end goal for every business is to get their money in and out of the tunnel as soon as possible without having to worry about hiccups along the way, like currency fluctuations or cash flow imbalances.
Trade finance has led to a massive increase in the volume of international trade and has contributed significantly to business growth. Here are the top 5 ways in which businesses can benefit from trade financing solutions:
- Bridge the working capital gap:
Trade finance facilitates the growth of businesses regardless of the capital they have at hand. Businesses can meet their short-term capital demand by paying their suppliers immediately with a host of trade financing solutions.
- Enjoy flexible financing
Trade financing provides cash flow flexibility and can be used as top-up financing. It could either be your main source of funding or it can supplement traditional financing options.
- Safeguard against fluctuating currencies:
When it comes to international trade, there is the concern of shifting exchange rates. The currency rates could drop or shoot up overnight. In which case the payment will be way different from what was agreed upon. Trade finance sets the exchange rate for the transactions upfront to safeguard the parties that are involved from paying more or being paid lesser than expected.
- Facilitate cross-border trade:
International trade comes with one too many risks. Bringing in trade finance solutions will ensure that your flow of transactions across the international borders is smooth and carried out with ease. It also makes trade a whole lot safer, assuring the importer that the goods will be delivered as per the terms and guaranteeing payment to the exporter for dispatching the goods.
- Benefit from making early payments
If you are an importer, having ready cash available to pay your supplier will help you take advantage of early settlement discounts that the supplier may offer. With trade finance, you will not only enjoy an extended period to repay your financier but you can also enjoy discounts on products and services that you purchase.
Power through with trade finance
Whether it is to fund exciting business opportunities or help you tide over trying times, trade finance has proven to help businesses scale up and reach the next level.
From closing the working capital gap, enabling financial flexibility to helping businesses tap into exponential growth, trade finance is driving businesses of all sizes and fuelling the global economy.
Think Working Capital…