Trade Finance Products | A complete guide
Different types of trade finance products help facilitate 90% of international trade, so what are your options? In this article, we break down exactly what is available for you on the market and how they work.
If you first want an in-depth look into what Trade Finance actually is check out our article here.
Revolving Trade Credit Line (known in the industry as a Trade Loan/Trade Finance)
Revolving trade credit lines (Trade Loan) allows your business to get access to a certain level of funding which you can use to pay your suppliers. The financing would be paid back once you receive payment from your customers similar to any other business loan.
Once the funds are paid back in full you plus an interest rate percentage of the value of your funding you can access the financing again. Funders will mostly only pay pre-vetted suppliers with a good credit history to limit their risk when facilitating trade transactions.
This funding type can cover any pre-shipment charges and deposits.
It is not uncommon for funders not to grant trade financing facilities without Invoice Financing facilities. This way they can see customer orders that you have and likewise who you are paying, ultimately limiting their risk as they see both sides of your transactions.
Technically as you are using the funder's capital to pay for the goods or services that you are importing they will own the product up until the point where you sell them to your customer. For this reason, funders like to deal with finished products that they can ultimately sell on should anything go wrong.
Businesses do struggle to get trade financing on unfinished products for example parts of a larger product that have a very specific need only to the end customer. This is due to the fact that it would be hard for the financier to recoup the value of the financing should your customer's default on the order.
For this form of secured financing, lenders will take security against the business to reduce the risks of funding the transaction, this can be secured on assets, debtors and also personal guarantees.
Recently challenger financiers have entered into the market to shake up the norm now offering unsecured Trade Finance facilities to customers who fit into their criteria. Mostly they look at the health of the business, if you are profitable and if your net assets have been increasing over the last 3 years.
These forms of unsecured trade finance facilities are a lot harder to access than conventional secured with financiers looking for a profitable and strong business to partner with. They will also insist that you undertake your foreign exchange transactions through them to gain extra margin. We look into how to keep your foreign exchange costs down here.
The maximum we find that can be granted on unsecured facilities is 30% of net assets. This is the top end of what you can be offered but more commonly we see 20-25% of net assets being offered as a facility size.
Letters of credit
Derived from travellers credits in the 18th Century Letters of credit now facilitate a large portion of global trade. There are a few variations available to your business which we will break down below.
Commercial letters of credit
The most widely used letter of credit form is where an importers bank will issue a guarantee to the exporter that they will be paid on issue of a bill of lading showing the goods quantity, specification and destination when they are loaded onto a ship or plane.
This allows the importer to limit the cash flow gap between when they pay for goods and when they are ultimately paid. Likewise, this provides increased security for the importer as they will only release the funds once they know that the goods have been finished and are on their way to them.
Exporters can use this letter of credit issued by the importer’s bank to gain funding from their own banks due to the bank guaranteeing the transaction.
Standby letters of credit
A standby letter of credit is a guarantee to a supplier that should the importer not pay for the goods the bank will issue the payment to the supplier. This would only be triggered if the importer does not pay for the product that they are importing.
For the exporter, this provides peace of mind that ultimately they will be paid for products that are provided. This can be particularly useful for contracts with long payment terms and likewise high volume transactions due to it eliminating the risk that the exporter would normally take on.
Likewise, with other forms of letters of credit, this is useful when the exporter does not know the importer and visa versa. Helping clients to place large orders with suppliers this can be a useful tool when conducting international trade.
Recoverable letters of credit
This type of letter of credit is not commonly used in international trade due to the increased risk that the exporter has to take on. Whilst the fundamentals of the product are still there the supplier dislikes this form due to the fact that banks can alter the letter of credit at any time without seeking the exporter’s approval.
The bank can change the date that the letter lasts till, the terms of the contract or full out refuse to pay the supplier. This is commonly used in countries where there are political instabilities or bad market conditions.
Irrevocable letters of credit
Most common out of the letters of credits that can be cancelled this guarantees payment to the supplier but serves to only make changes to the binding document should all parties involved consent to do so (including the issuing bank).
This form of a letter of credit can be confirmed or unconfirmed. Confirmed would mean that the exports bank would also agree to pay the transaction should anything go wrong with the buyer’s payment, increasing the seller’s protection. This is more enacted when the export does not trust the importer’s bank.
Unconfirmed would be where the importer’s bank would be solely guaranteeing the transaction.
Revolving letters of credit
Revolving letters of credit are useful when you agree to undertake long term business with a supplier. These normally last for a period of one year but can also be based on the value of the overall continued work or production of products and services.
It is still a single letter of credit but covers continued work by the supplier over the course of that year. This can only be used by the particular importer and exporter and ultimately stops the importer from having to go back to the bank every time they need a transaction financed saving time for all parties involved.
Red clause letters of credit
The name red clause was initially derived from the fact that banks would write these types of letters of credit in red ink.
Slightly different to other options we have gone over, the buyer issues an advanced loan (partial value of the order) to the exporter to help bolster their working capital for facilitating production. These advances are then take off the value of the total order once the importer has to pay.
Most commonly buyers will be hesitant to provide this type of letter of credit due to the risk that they have to take on their part, this mostly works with importers and exporters who have existing, long-term relationships.
Invoice Finance
Invoice Finance allows business to sell their invoices from their customers in exchange for an advance on those given invoices. This is typically up to 90% of the value of those invoices.
There are variations on the product which we will dive into now.
Invoice Finance
This is where you sign an agreement with a financier to sell your invoices to them in exchange for an advance. Normally there are a number of charges involved in this product including an interest rate on the leant funds as well as a minimum fee.
The minimum fee is the minimum amount which you as a customer will be charged annually for holding the facility. These costs can range massively depending on what position your company is in, we look further into this here.
The leant amount against the invoice will then be paid back to the financier once the invoice is settled by your customer. Normally (but not always) the funds will be paid back into ‘client accounts’ which are held under your companies name.
Funds that are made available to you by the financier can be used for paying for supplies to facilitate the order, paying employees and also reinvesting in your operations. You also grant the funder the right to contact your customers in order to receive payment, they will do this to protect themselves from the risk of your customer not paying.
One thing to take note of with this type of facility is normally you are tied in with long term contracts with heavy penalties should you want to exit out of it early. It is always worth checking the fine print on these types of contracts.
We delve further into Invoice finance and its different facets here.
Invoice Discounting
Much like its sister product above invoice discounting is a short term form of funding for your business that releases cash flow from your invoices (receivables). The only main difference with invoice discounting is that you manage your customer collections and credit control.
A large portion of businesses doesn't like their customers knowing that they are financing as it can put some businesses off from dealing with you as they think that your business is ‘distressed’. Most of the time this is not the case and businesses use this to bolster their cash flow, but there is a preconception out there.
Like Invoice Finance you will usually have to give some form of security against an Invoice Discounting facility. This can be through assets, debentures and personal guarantees.
Similar to the fees incurred on an Invoice Finance Facility you will also have to pay a ‘discounting charge’ and a running fee. The fees can vary massively depending on which financier you use and we have seen some charge 7 separate fees.
Purchase Order Finance
A purchase order is an agreement between a buyer and a seller. The buyer will approach the seller with a purchase order that he needs to get filled. This will include what the product is, the quantity, quality time it takes to deliver and other variables.
Once the seller agrees to the purchase order terms it becomes legally binding for the supplier to fulfil that order and likewise for the buyer to pay for the order once the terms are met. Due to the nature of the agreement banks will fund against the purchase order value.
Releasing funding from your purchase order can help you fulfil orders from clients whereas previously you might have not been able to.
Pre-Export Finance
Hence the name Pre-Export Finance is a bank or financial institution advancing funds on exporters secured orders from a client. Normally the exporter doesn't have enough liquidity to meet the production of an order so they would approach a financial institution to help with production costs to help facilitate the export trade.
We tend to see this used for larger contracts over a long period of time where the financial commitment by the exporter can be vast. The industries that mostly use this type of finance are commodities and farming companies.
Once the ultimate order is completed the exporter's client would pay directly into the financing facilities bank where any interest occurred would be paid and likewise any further charges.
Due to the extra liquidity provided to the exporter, this also allows the buyer to secure larger orders where otherwise they couldn’t.
Conclusion
There are other forms of less commonly used financing out there including supply chain finance and prepayment finance which we cover here.
When conducting trades internationally or nationally trade financing products can be an essential part of your businesses growth. Our team of industry experienced consultants can help you find the right route for your business, get in touch with us here.
