Trade Finance Explained: 5 Facts You Need To Know

A look into trade financing and how it impacts your business

Trade finance is a type of international trade whereby trading intermediaries such as banks and other financial institutions facilitate different transactions between the buyer ( importer) and the seller ( exporter). In simple terms, these financial institutions are there to finance the business transactions between the buyer and the seller.

Trade finance has different types of activities such as issuing letters of credit, lending, export credit and financing and factoring.

Trade financing is facilitated by different companies including the buyer and the seller, the trade financier, export credit agencies and insurers. Different books and publications have had trade finance explained in detail. However, not many people have access to these hard copies. Are you among them? You shouldn't worry, here is quick look at different facts you have to know about trade finance and how it has led to enormous growth of international trade.

1. It Acts As A Risk Mitigation Method

During the early days when international trade began, many exporters were never sure whether the importer would pay them for their suppliers. With time, the exporters wanted to reduce the payment risk from the importer. On the other hand, the importers were also worried about making prior payments for the goods to the exporter since no one was sure on whether the seller would ship the goods.

Thus, trade finance tends to reduce all these risks by accelerating the payment to the exporter and assuring the importer that all the goods ordered have been shipped.

The importer's bank works to provide the exporter with a letter of credit to the bank of the exporter as payment when shipment documents such are presented.

Alternatively, the exporter's bank may give a business loan to the exporter while still processing the payment made by the importer in order to keep the supply of goods active instead of the exporter waiting for the payment made by the importer.

The loan extended to the exporter will be recovered by the trade financier when the importer's payment is received by the exporter's bank.

2. It Reduces The Bulk On Both The Importer and The Importer

Trade finance as said before has led to enormous growth of economies across the globe since the gap that used to be there before between the exporter and the seller has been bridged. The exporter is no longer afraid of the importer's default in payments. On the other hand, the importer is sure that all the goods ordered have been sent by the exporter as verified by the trade financier.

3. Trade Finance Products and Services

Trade financiers such as banks and other financial institutions enhance the transactions between the exporter and importer by offering different products and services.

Letter of Credit

This is a promise undertaken by the importer's bank to the exporter in that when the exporter presents all the shipping documents as spelled out by the importer's purchase agreement, the bank will immediately make the payment to the seller.

Bank Guarantee

Here, the bank acts as a guarantor in case the importer or the exporter fails to fulfill the terms and conditions of the contract. The bank takes an initiative to pay a sum of money to the beneficiary.

4. Factoring In Trade Finance Explained

This is a very common method used by exporters in order to accelerate their cash flow. In this type of agreement, the exporter sells all his invoices to a trade financier ( the factor) at a discount. The factor then will wait till the payment is made by the importer. This relieves the exporter from bad debts and provides working capital for them to keep trading. The trade financier then makes a profit when the importer pays for the goods since the exporter gives out the account receivables at a discount to the financier while the buyer pays the total amount as agreed with the seller.

5. Forfaiting

This is a form of agreement whereby the exporter sells all his account receivables to a forfaiter at a certain discount who pays cash. By so doing, the exporter transfers the debt he owes to the importer to the forfaiter.

The receivables bought by the forfaiter however must be guaranteed by the importer's bank. This is due to the fact that the importer takes the goods on credit and goes ahead to sell them before paying the forfaiter.