Global supply chains are now more interconnected and interdependent than ever. Co-operation at a global level has ensured that countries and businesses have access to both finished goods, raw materials and services at the right time. This has fostered a spirit of innovation and co-operation at an unprecedented scale.
However, at an individual business-level, several choke-points and barriers exist and many of these can be addressed with the help of novel business solutions and products that rely on simple human ingenuity assisted by technology.
This is particularly true in case of business financing. In a survey conducted by BusinessWire in 2017, 6 out of 10 businesses in the United States reported that they were struggling with working capital issues that stifled business growth.
Many of these are global businesses with import, export, and domestic operations as well.
Due to supply chain challenges, lengthy documentation requirements and state involvements, these working capital challenges are amplified in international trade.
This article is an attempt at defining trade finance, its current role in global trade, and legacy trade finance products that businesses utilize. It also sheds light on a few relatively new products that export-import businesses can leverage.
Definition of Trade Finance
Trade finance refers to the variety of financial services and goods that companies use to facilitate cross-border trade and business. These financial tools help importers and exporters perform commercial operations more efficiently and affordably.
Trade finance is an umbrella term for various financial products businesses use to facilitate trade.
Importance of Trade Finance for Global Businesses
Trade finance allows businesses to:
- Facilitate cross-border transactions: Trade finance assists companies in managing the monetary aspect of global commerce. It enables them to carry out cross-border transactions and expand their commercial operations.
- Reduce financial risks: Cross-border trade involves various risks, such as currency volatility, payment defaults, and political instability. Trade finance provides financial support and helps mitigate these risks. This allows businesses to engage in international trade confidently.
- Improves cash flow position: Trade finance solutions like factoring, invoice discounting, and supply chain finance assist companies in accessing working capital. This is necessary for growth, expansion, and improved cash flow position.
- Access new markets: With the funding trade finance offers, companies can finance imports and exports, manage cash flow, and reduce risks. This helps firms enter new markets and increase their client base.
- Enhance competitiveness: Access to trade finance solutions enables businesses to offer their clients favorable payment terms, reduce transaction costs, and manage cross-border commerce more effectively.
Challenges Associated with Traditional Trade Financing
While traditional trade finance solutions like letter of credit, bank guarantees and secured bank loans are at least partly responsible for the earliest spurts in global trade, in the current scenario they suffer from some critical drawbacks.
- Lack of Transparency: This is one of the biggest issues with global trade financing. Financial institutions and banks find evaluating the risk involved in any given trade transaction to be quite challenging. An inaccurate understanding of risks will result in obscure pricing and the business may not enjoy pricing that is commensurate with the risk associated with the transaction
- Complexity: Traditional trade financing has a complex and time-consuming documentation process. Traditional trade financing techniques also suffer from the same problem. However, businesses operating in the free-market need to be competitive and quick with their decision making and execution.
- Cost: While the intrinsic cost of the financing product itself may be the same, the hidden costs of opting for traditional financing techniques like opportunity cost, human capital cost for adhering to compliances etc, costs incurred due to the incessant delays etc are quite high.
Advantages of Using Alternative Trade Finance Products
Using alternate trade finance products can offer many benefits for scaling businesses globally.
- Faster processing time: Compared to traditional trade finance, many alternative products are designed to be quicker and more effective. Businesses can acquire financing more quickly, improving their ability to seize opportunities.
- More flexible terms: Alternative trade finance products may provide more flexible terms, enabling businesses to customize the funding to meet their unique requirements. This may entail changing the amount of the loan, the interest rate, and the collateral requirements.
- Risk reduction: Alternative trade finance products can help reduce risk by offering businesses trade finance options. These products are created to lessen risks connected to international trade, such as currency volatility, political unpredictability, and credit risk.
- Better transparency: Several alternative trade finance products leverage cutting-edge technologies throughout the trade transaction. All parties engaged in the trade transaction may feel more confident, which can reduce risks of fraud, mistakes, and conflicts.
Types of Alternate Trade Finance Products
Before we proceed, we would like to thank the team at Drip Capital for lending their expertise for developing this post. They are experts in trade finance and have many detailed guides on related subjects.
Give this finance guide a read if you would like to learn more about trade financing directly from them.
Invoice Financing & Factoring
Invoice financing (specifically, factoring) is a trade finance product in which a business sells its invoices to a financial institution for immediate liquidity. The financial institution pays a portion of the invoice upfront; the remaining amount, minus the fees, is paid when the invoice is paid.
There are two types of funding – invoice factoring and invoice discounting.
Invoice factoring involves selling unpaid accounts receivable to a factoring company at a discounted rate. This is technically a financing technique by way of selling the asset (the invoice).
Whereas invoice discounting involves borrowing money against the value of outstanding invoices.
- Immediate access to liquidity, factoring or invoice financing companies are generally experts in global trade and have a sound understanding of the complexities associated with it and the urgency of accessing liquidity
- In most cases, the financing requires collateral
- Proper risk-mitigation, factoring companies absorb the risk of non-payments, delays, force majeure events etc and the business can continue fulfilling orders and improve operational processes instead of chasing customer payments
- Given the fact that the invoice financing company or the factoring company specializes in international trade, many of them also act in an advisory capacity and suggest the best course of action. This includes referring vendors, customers etc to the business from time-to-time that can prove invaluable in the long-run
- These products generally operate as a credit line, so customers are not charged unless they draw down a loan from the overall financing facility. This provides unparalleled flexibility to businesses looking to optimize their borrowing costs.
- The absolute costs of this product can exceed the cost of conventional bank loans
- May require companies to give financial institutions access to sensitive financial data
- The borrowers customer’s clients may feel doubtful that another institution is following up for payment instead of the seller and may hamper relationships in the long term
- Only companies with a strong customer base and a history of producing invoices may be eligible
While the eligibility requirements vary wildly for every business, a general eligibility criteria can be found below.
- A specific deadline (often within 90 days) must be met for invoices to be paid in full.
- The company must have a strong credit standing and a history of producing invoices.
- The company should typically have a steady customer base with little chance of customer default.
- The company sends the financial institution its invoices for funding.
- The financial institution examines the bills and the consumers’ creditworthiness.
- The financial institution initially advances a portion of the invoice once approved (typically between 70% and 90%).
- When an invoice is due, the financial institution collects payment from the client and sends the pending amount, minus the fees, to the company.
Purchase Order Financing
A purchase order is a commercial document governed by the Uniform Commercial Code. While the document itself is not a contract, it is legally enforceable. Thus, the purchase order can be a useful document for backing a business loan or any form of financial advances.
A purchase order is a document that is issued by the buyer to the seller declaring their confirmed intent to place an order for the goods. Provided, the underlying commercials and quality standards are maintained, it is a guarantee that the buyer will honor his payment for the order.
Given the legal backing, banks, and financial institutions can take refuge in a purchase order and offer financing against the document to cash-strapped and growth-driven sellers/exporters in the United States and globally.
We like this brief article compiled by Trade Finance Global that helps simplify purchase order financing as a product.
- Companies with a relatively poor credit history, weaker financials fare better in securing financing through this method since the order is practically confirmed and it is the buyer’s credit profile that is considered for financing
- Smaller companies and startups with an innovative and in-demand product can easily secure larger orders without worrying about borrowing limits. This can significantly help a small company scale very quickly with the aid of little to no external funding
- Does not require any personal or business collateral
- May require companies to provide financial institutions access to sensitive financial data
- May also require companies to reveal manufacturing processes and other sensitive operational processes. This requirement varies from financier to financier
- Only companies with a solid customer base and a history of completing orders might be eligible
- The borrowing company must have a track record of completing orders.
- The company must have a strong financial position and credit rating.
- The company files a purchase order to the financing institution for approval.
- The financial institution confirms the purchase order and the customer’s creditworthiness.
- The financial institution approves and gives the money required to complete the purchase order.
- The company sends the finished product to the consumer.
- The financial institution receives payment from the consumer directly or through the business.
- Before transferring the remaining amount to the firm, it deducts the cost of financing and other expenses.
Supply Chain Financing
Supply chain financing (SCF) is a buyer-led trade financing product that addresses cash flow and pricing concerns for both the customer and the seller in a supply chain by leveraging the buyer’s credit profile. This benefits both the buyer (or importer) as well as the seller (or exporter).
In essence, this means that the buyer arranges for paying his sellers directly by the financier by leveraging their own credit profile. For developed countries with large institutional buyers and a global network of suppliers across the globe, such a financing arrangement can prove to be both cost-effective and scalable.
- Since the buyer’s credit profile and financials are considered for the pricing & limits, this financing solution assists suppliers in obtaining access to affordable financing
- The entire facility is like a line of credit that has already been sanctioned, disbursements are almost immediate and require basic documentation like the invoice and shipment details
- An improved commercial relationship to the benefit of the buyer since the financing concerns of the seller is minimized
- May entail execution and management challenges
- Necessitates intensive coordination between supply chain participants
- May not be appropriate for all supply networks
- A solid long-term relationship between the buyer and the supplier is necessary.
- The supplier needs to be in good financial and credit standing.
- The buyer must have a strong credit history and a record of promptly paying invoices.
- Both the customer and the supplier consent to participating in SCF.
- The financial institution examines the buyer’s and the supplier’s creditworthiness.
- The financial institution offers supplier financing.
- When the invoice is due, the buyer accepts the invoice and pays the financial institution.
- After deducting fees and financing costs, the financial institution pays the supplier the invoice amount.
Factors to Consider When Choosing a Trade Finance Product
Here are three factors to be considered while finding the most suitable financing solution.
Business Type and Size
Different types and sizes of firms are suited for different trade finance products. For instance, larger companies might favor letters of credit or supply chain finance. Small companies might profit more from factoring or purchase order financing.
Industry and Demographics
When selecting trade finance products, it’s critical to consider a company’s industry and geographic location. Both these aspects have their unique issues and characteristics that could affect the ease of accepting certain trade finance products. Businesses can handle their unique needs and issues and fulfill financial objectives by selecting the appropriate trade finance solution.
When selecting trade finance products for a firm, companies should consider the number of transactions. They can select a trade finance product best suited to their specific needs and optimize their cash flow.
Credit Profile (Of all parties)
When selecting trade finance products for a firm, companies should consider the number of transactions. They can select a trade finance product best suited to their unique needs and optimize their cash flow.
While banks continue to remain one of the chief sources of financing, especially for businesses focused on optimizing borrowing costs, novel trade financing techniques offer tremendous flexibility for businesses.
Securing a sanction on these facilities has minimal costs and businesses can opt for drawing down from these sanctioned amounts based on business exigencies and priorities.
A mix of traditional banking products as well as relying on more flexible, modern products is the most prudent option for businesses in the age of fin-tech, globalization and increasing complexity of supply chains to scale businesses globally.