How to use trade finance to trade (mostly!) risk-free

If you’re new to the concept, trade finance can be pretty confusing.

A quick online search will bring you so many different definitions that you’ll probably be left scratching your head, trying to figure out what trade finance even is – let alone how you can use it in your business.

Confusing about Trade Finance Illustration

I have to admit, a lot of the information out there isn’t all that clear. That’s why I’ve put together this guide. Because if your business plan includes international trade, you could really benefit from some of the trade finance tools you’ll read about in this article – but only if you understand them!

You need to know what trade finance is for, what instruments there are, how they work and what pitfalls to watch out for.

You’ll find all that information here.

I’ll start with the basics.

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What is the point of trade finance?

This is how the Global Trade Review defines trade finance:

“Trade finance is the financing of international trade flows. It exists to mitigate, or reduce, the risks involved in an international trade transaction.”

Okay. But what does that actually mean?

Let’s break it down a little more.

If your business is making international transactions, there’s a certain amount of risk involved, right?

Of course, there’s risk involved in most business transactions – and you don’t have to be trading oversees to use trade finance. But trade finance tools are more commonly used in international because cross border-transactions are more risky.

Here’s why:

You may not be familiar with the company you’re trading with, and it may be hard to find out everything you need to know about the company – like their credit rating, their reputation in the market and whether they have a history of paying for goods or fulfilling orders on time.

There are lots of things that can go wrong when you’re transporting goods long distance, which could cause serious delays in delivery.

Currencies could move between the time you place the order and the time you pay for it (or the time you get an order and receive payment, depending on whether you’re buying or selling) – making the transaction more expensive or less profitable than you expected.

If there’s any sort of political or social instability in the country you’re trading with, your transaction could get disrupted (for example, seized at customs).

If something does go wrong, it’s much harder to sort things out when you’re dealing with a different legal and regulatory system, culture and language.

Trade finance tools are designed to mitigate or eliminate some of these risks. They’re also there to help you to fill funding gaps in your international trade cycle – which brings me to the other main reason business owners use trade finance:

Cash flow.

If you’re making and selling goods, you’ll have a whole heap of costs to bear up front – including raw materials, manufacturing, storing and shipping. If you offer credit terms you could have to wait between 30 and 90 days for payment, and with overseas shipping you could still have a long wait for payment even if your terms are cash on delivery.

Business Credit Term Illustration

In the meantime, you’ll have to cover all your fixed costs – salaries and super, insurance and tax – plus all the variable costs of the next order you need to fill.

I’ll take you through the cash flow benefits when we look at each type of trade finance tool.

But for now, back to the big question:


How does trade finance mitigate risk?

Here’s the basic problem at the heart of international trade:

  • If you’re buying, you want to be certain that your goods will arrive, on time and in good condition, before you pay. If you pay in advance, there’s a risk the seller will simply pocket your hard-earned cash and never ship the goods.

  • If you’re selling, you don’t want to ship the goods until you know they are going to be paid for – you certainly don’t want to wait weeks for the goods to travel to their destination and clear customs to find out if your seller is going to pay their bill.

To make the trade work, one party has to take a risk. So, either:

A (Seller takes risk)

The seller has to ship the goods on credit terms and trust that the buyer can and will pay for them when they receive them. As well as the risk, they have to finance the long gap between paying to produce and ship the goods, and getting paid by their customer.

Seller Unhappy Illustration

B (Buyer takes risk)

The buyer has to pay for the goods up front with no guarantee that the goods will be of reasonable quality or that they’ll even receive them at all. As well as the risk, they have to finance the long gap between paying for the products, and being able to use them in their own business to generate income.

Customer Unhappy Illustration

Trade finance tools introduce a trusted third party – a bank or finance company – who acts as a go-between to remove some, or all, of the risk for you and your trading partner.

Trade Finance Remove Risk Illustration

For a fee, of course!

The exact role that third party will play will depend on the type of trade finance instrument you use. So, let’s look at your options.


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What trade finance tools are there (and how can they benefit your business?)

1

A letter of credit

Let’s say you want to buy international goods. You can go to your bank and show them the purchase order. The bank assesses your credit and issues a document called a ‘letter of credit’. Often, they’ll collect payment in full from you – for the goods and the letter of credit service – at this point.

You can then send a copy of this document to the exporting company’s bank, to prove that you have good credit and the means to pay for the goods you’ve ordered. Once they’ve checked it over, the exporter’s bank will assess the terms and (hopefully!) clear the goods for shipment.

Once they’ve shipped the goods, the exporter shows proof of shipment to their bank and their bank pays them. Their bank then forwards the shipping papers to your bank, and your bank pays them and collects payment from you.

If that still sounds confusing, here’s a quick step-by-step guide:

Letter of Credit Step 1
1

You (buyer) approach bank A to ask for a letter of credit

Letter of Credit Step 2
2

Bank A checks your creditworthiness or collects your payment, and issues a letter of credit

Letter of Credit Step 3
3

You send the letter of credit to bank B (the seller’s bank)

Letter of Credit Step 4
4

Bank B checks the letter of credit and assures the seller that you are creditworthy

Letter of Credit Step 5
5

The seller ships the goods and sends proof of shipping (such as a bill of lading) to bank B

Letter of Credit Step 6
6

Bank B pays the seller then forwards the shipping documents to bank A, so you can collect your goods on arrival

Letter of Credit Step 7
7

Bank A pays bank B (and collects payment from you if you haven’t paid in advance).

A letter of credit reduces risk for the seller by:

  • Proving that the buyer can afford to pay for the goods.
  • Guaranteeing that they’ll get payment (through the banks) once they ship the goods.

And for the buyer by:

  • Ensuring that the seller has shipped the goods before their bank releases payment.

It’s always the buyer who organises the letter of credit. So if you’re exporting goods, then your customer will have to get the ball rolling – but if you’re importing then it’s up to you.

  • You can buy a letter of credit in advance, which means you’ll pay, up front, the purchase price of whatever you’re buying plus the bank’s fee for the letter of credit service. The bank will then hold your funds in escrow and only release them to the seller’s bank once they have proof that your goods have been shipped.

  • If your credit rating is high enough, you have a solid trading history and you have collateral to offer, you may be able to defer payment until you’ve received your goods. This means that your bank will pay the seller’s bank when they receive proof of shipping and then collect the funds from you later, effectively giving you a short-term loan. You’ll inevitably have to pay a higher fee for this service.

Letters of credit are a popular tool and they do help to reduce the risk of international trade, but there are a few pitfalls:

  • Having two banks involved can really slow down transaction times.

  • There’s still no guarantee that the goods will arrive on time or be of reasonable condition.

  • Unless you can arrange to defer payment (and are willing to pay the fee for this service), you’ll still have to fund the gap between paying for the goods and receiving them.

2

A guarantee

Like with a letter of credit, using a guarantee means that you’ll have a third party – a bank or lender – step in to carry some of the risk of the transaction.

The point of this arrangement is to guarantee that the other party won’t lose money if you don’t hold up your end of the bargain, so that they’ll feel safe enough to deal with you.

Unlike a letter of credit, which is always arranged by the buyer, either side in a transaction can arrange a guarantee. In fact, it’s common for both sides to have one.

The big difference between a letter of credit and a guarantee is that your bank or financial institution will only get involved if something goes wrong. At that point, they become legally responsible for making sure the other party doesn’t lose out if you fail to fulfil your part of the contract.

So if you get the goods but don’t pay for them, your bank will have to step in and compensate the seller. And you pay but the seller doesn’t send the goods, their bank will have to compensate you.

As you can imagine, that level of risk comes at a cost, so guarantees are mostly used for high-value deals in both domestic and international trade (like infrastructure or property transactions).

Buying Property Guaranteed Illustration

Given how most banks feel about risk, the odds are you’ll only be able to get a guarantee if yours is a well-established business with a strong trading history and a solid credit rating.

3

Documentary collection

Documentary collection protects you if you’re exporting goods. It’s a cheaper and quicker option than a letter of credit and it’s something you can arrange yourself, rather than relying on the buyer to organise it.

But…

…it won’t offer you the same level of protection as a letter of credit, so it’s a tool you’re more likely to use with a trusted trade partner rather than a new contact.

Here’s how it works:

Documentary Collection Step 1
1

You ship the goods and send the shipping documents to your bank

Documentary Collection Step 2
2

Your bank shows the documents to the buyer’s bank to prove you’ve fulfilled your end of the bargain

Documentary Collection Step 3
3

The buyer’s bank lets the buyer know that they’ve seen proof of shipping and requests payment

Documentary Collection Step 4
4

The buyer pays their bank, who in turn pays your bank (or provides 30-, 60- or 90-day bill of exchange – more on these in a minute)

Documentary Collection Step 5
5

Your bank releases the shipping documents, so the buyer can take possession of their goods on arrival.

While this does mean the buyer can’t collect their goods without paying for them, there’s nothing to stop them changing their mind and refusing to collect the shipment. Which could leave you well and truly in the lurch – with no payment and a consignment of goods in a foreign port and all the cost and hassle of getting it back.

So documentary collection does give you some peace of mind, but nothing like the protection you’d get from a letter of credit or a guarantee – which is why it’s so much cheaper!

4

Bill of exchange

A bill of exchange, also known as a ‘promissory note’ or ‘draft’ is like an endorsed cheque (remember those?!). Here’s one...

Bank Cheque Sample

Basically, it’s a promise (a legally binding one!) that the buyer, or the bank that has issued the bill on their behalf, will pay a fixed amount on a fixed future date.

If your buyer offers you a bill of exchange drawn on a reputable bank, you can offer them credit terms with total assurance that you’ll receive payment when it falls due.

Even better, you may be able to sell the bill on to a third party, so you can get cash right away rather than waiting for the 30, 60 or 90 days to pass. You won’t get the full amount of the bill up front, as you’ll only be able to sell it at a discounted rate, but it can be a useful way to smooth out any cash flow issues during the credit period.

Bill of Exchange Change Hands Illustration

Whoever owns the bill on the date it falls due collects that payment. Bills can sometimes change hands several times.

5

Trade credit and political risk insurance

You can take out a trade credit insurance policy whether you’re importing or exporting, to protect you in case something goes wrong. That ‘something’ could be your customer not paying their bill or not shipping the goods as promised – or it could be something outside of either party’s control, like a sunk ship, a seized shipment, an act of terrorism or even war.

There are lots of insurance companies and export credit agencies that offer trade credit insurance and political risk insurance on different terms, so be sure to shop around if you’re thinking of buying it.

At this point you may be thinking:

“But there’s nothing special about insurance. Why are you listing this as a trade finance instrument?”

The thing is that as soon as you take out insurance, your unpaid invoice becomes a secured asset. You have a guarantee that you’ll receive payment – so now you can use that receivable as collateral for a business loan or other type of business finance.

6

Forfaiting

Forfaiting is also known as ‘factoring’ or ‘invoice finance’. It’s not just a trade finance tool – lots of domestic businesses use it too.

Forfaiting doesn’t address any of the risks of international trade – this one is strictly a cash-flow management tool.

Unlike most forms of business finance, forfaiting doesn’t involve taking on debt. Instead, you’ll be selling your accounts receivable – the unpaid invoices from your customers – to a third party.

Just like selling a bill of exchange, this means you can offer credit terms to your customers (making you more competitive) but still get your hands on most of the sale price right away. Which is great if you have lots of up-front expenses to cover.

Here’s how it works:

Documentary Collection Step 1
1

You make a sale and issue an invoice to your customer on 30-, 60- or 90-day credit terms

Documentary Collection Step 2
2

You sell the invoice to a forfaiting company and receive up to 90% of the invoice value right away (the percentage will vary depending on the finance provider)

Documentary Collection Step 3
3

When the invoice falls due, the forfaiting company collects payment from your customer

Documentary Collection Step 4
4

The forfaiting company deducts their fee and then transfers the remainder to you

As well as giving you quicker access to your sale proceeds, forfaiting means that you don’t have to worry about chasing debts from your customers.

Most of the time.

Having said that, there are two types of forfaiting: recourse and non-recourse. With non-recourse factoring the transaction is a done deal. If the customer refuses to pay up, all you’ll lose is the residual payment you’d have got from the forfaiting company.

With recourse factoring, on the other hand, you could end up having to buy back the invoice if the customer doesn’t pay. As you can imagine, this is usually cheaper than the non-recourse option as it’s much less risky for the forfaiting company.

The other big advantage of forfaiting is that it’s easy to access – the lender will look more at the creditworthiness of your customers than at your own business, so you may be able to use it even if you’ve not been in business very long, or if your credit score isn’t great.

But there are some pitfalls to watch out for.

  • Forfaiting can be pretty expensive – if you qualify for a small business loan or line of credit you may be able to use that instead to cover your working capital fluctuations in a more cost-effective way.

  • Some forfaiting companies will lock you into a contract where you have to sell all your invoices in a specific period, or all the invoices you issue to certain customers (the most reliable ones, usually!)

    This means you could end up having to sell your invoices and paying the forfaiting fees even when your cash flow is strong, and you don’t need the finance. You may be able to opt for flexible forfaiting, where you can pick and choose which invoices you sell, but you can definitely expect that to be more expensive.

  • You could end up putting your reputation on the line if you use a forfaiting company. You’ll have no control over how they’ll behave towards your customers, which could end up costing you precious business.

Right, that’s the main trade finance tools covered. But there are a few more things you need to know.

Such as the exciting news that if you’re just getting started exporting goods from Australia, you may qualify for an Export Market Development Grant. Even if you don’t, you’ll find lots of valuable information on the Australian Trade and Investment Commission website that could help you get established.

You can also look into…

Export credit agencies

These are government-owned agencies that offer government-backed loans to businesses within Australia that are looking to develop business overseas. They also provide government-backed guarantees and insurance.

Structured trade and commodity finance

Structured trade and commodity finance tools are tailored loans specifically designed to suit your circumstances, your transaction, and your region. These are typically long-term loans and they can take various forms, such as:

  • Pre-export finance – where you can use your use export contracts as collateral to raise money.

  • Revolving credit facilities – where you can borrow, repay and reborrow funds as often as you need to, up to an agreed credit limit and over an agreed period (only paying interest on the funds you draw down).

  • Borrowing base facilities – a form of working capital credit secured by your assets.

  • Warehouse financing – where you use goods you hold in a warehouse as collateral for a loan and hand over management of those goods to a third party.


Conclusion

We live in an increasingly interconnected world. This means that it’s getting easier and easier to buy from and sell to people and businesses almost anywhere on the planet.

This means you could have access to a world-wide customer base – but it doesn’t come without risk. It can be a lot harder to check out a potential trade partner if they’re based in another country. And if something goes wrong, it can be much more difficult to fix a problem when you’re dealing with different legal systems, languages and cultures.

Trade finance tools have been developed to offset some of those risks, so you can import or export without worrying as much about not getting what you’ve paid for, or not receiving payment for the goods you send.

These tools can also help solve the other major problem of international trade – the timing gap between your outlay on making and shipping goods and receiving payment (or between paying for goods and receiving them) – and the cash flow worries that gap can cause.

Although trade finance can seem pretty confusing, these tools can make international trade much safer, so it’s well worth getting your head around them if you’re planning to buy or sell cross-border.

Have you ever used a trade finance tool? How has it worked for you? Has it helped to grow your business? Let me know in the comments below!

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