Corporate Finance & Accounting

trade finance

What is trade finance?

Trade finance represents the financial instruments and products that companies use to facilitate international trade and commerce. Trade finance makes it possible and easy for importers and exporters to conduct business transactions through trade. Trade finance is an umbrella term that means it covers many financial products that banks and companies use to make trade transactions feasible.

key takeaways

  • Trade finance represents the financial instruments and products that companies use to facilitate international trade and commerce.
  • Trade finance makes it possible and easy for importers and exporters to conduct business transactions through trade.
  • Trade finance can help reduce risks associated with global trade by reconciling the different needs of exporters and importers.

How Trade Finance Works

The role of trade finance is to introduce a third party into the transaction to eliminate payment risk and supply risk. Trade finance provides receivables or payments to exporters under an agreement, while importers may provide credit to fulfill trade orders.

There are many parties involved in trade finance, including:

Trade finance differs from traditional financing or credit issuance. General financing is used to manage solvency or liquidity, but trade financing does not necessarily indicate a lack of funds or liquidity on the buyer side. Instead, trade finance can be used to protect against the unique inherent risks of international trade, such as currency fluctuations, political instability, non-payment issues or the credibility of one of the parties involved.

Here are some of the financial instruments used in trade finance:

  • Banks can issue lines of credit to help importers and exporters.
  • Letters of credit reduce the risks associated with global trade because the buyer’s bank guarantees payment for the goods to the seller. However, the buyer is also protected because payment will not be made unless the seller meets the terms in the letter of credit. Both parties must abide by the agreement in order for the transaction to proceed.
  • Factoring refers to paying a company based on a percentage of accounts receivable.
  • Export credit or working capital can be provided to exporters.
  • Insurance is available for shipping and delivery of goods, and also protects exporters from non-payment by buyers.

Although international trade has existed for centuries, trade finance has facilitated its development. The widespread use of trade finance has contributed to the growth of international trade.

“About 80 to 90 percent of world trade depends on trade finance…” – World Trade Organization (WTO)

How trade finance can reduce risk

Trade finance can help reduce risks associated with global trade by reconciling the different needs of exporters and importers. Ideally, the exporter wants the importer to prepay for the exported goods to avoid the risk of the importer picking up the goods but refusing to pay. However, if the importer pays the exporter in advance, the exporter can accept the payment but refuse to ship.

A common solution to this problem is for the importer’s bank to provide a letter of credit to the exporter’s bank, and payment can be made once the exporter presents documents proving the shipment took place, such as a bill of lading. The letter of credit guarantees that payment will be issued to the exporter once the issuing bank receives proof that the exporter has shipped the goods and that the terms of the agreement have been met.

With the letter of credit, the buyer’s bank assumes the responsibility of paying the seller. The buyer’s bank must ensure that the buyer is financially viable enough to honour the deal. Trade finance helps importers and exporters build trust in each other’s transactions, thereby facilitating trade.

Trade finance gives both importers and exporters access to a number of financial solutions that can be tailored to their circumstances, and often multiple products can be used in tandem or in layers to help ensure a smooth transaction.

Other Benefits of Trade Finance

In addition to reducing the risk of non-payment and non-receipt of goods, trade finance has become an important tool for businesses to improve efficiency and increase revenue.

Improve cash flow and operational efficiency

Trade finance helps companies obtain financing to boost their business, but in many cases it is also an extension of credit. Trade finance allows companies to receive cash payments against accounts receivable under factoring. Letters of credit can help importers and exporters conduct trade transactions and reduce the risk of non-payment or non-receipt of goods. As a result, cash flow improves thanks to the buyer’s bank-guaranteed payment, and the importer knows that the goods will be shipped.

In other words, trade finance ensures that payment and shipment delays are reduced, allowing importers and exporters to conduct business more efficiently and plan cash flow. Think of trade finance as using the transportation or trade of goods as collateral to finance your company’s growth.

Increase revenue and earnings

Trade finance allows companies to increase their business and income through trade. For example, a U.S. company that can sell to overseas companies may not have the capacity to produce the goods required by the order.

However, with the help of export finance or private or government trade finance agencies, exporters can fulfill orders. As a result, the U.S. company has secured new business that it might not have had without the creative financial solutions offered by trade finance.

Reduce the risk of financial hardship

Without trade finance, companies could fall behind on payments and lose key customers or suppliers that could have long-term effects on the company. Having options like revolving credit facilities and accounts receivable factoring can not only help companies transact internationally, but also help them in times of financial distress.

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