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What is trade finance? Know its benefits and how it works

Trade finance uses financial tools to supports international transactions and ensure fulfilment of obligations between exporters and importers by using financial tools. Learn more about trade finance.

International business often involves financial risks like delayed payment and non-delivery of goods. Trade finance refers to the various tools and processes through which companies secure the required funds to support international transactions. Trade finance helps reduce risks, enabling secure and efficient trade transactions at the international level. In this blog post, we will explore trade finance's definition, principles, benefits, various trade financing choices, and risk minimization techniques.

What is trade finance?

Trade finance is an umbrella term which covers many financial tools that are aimed at supporting international business transactions, managing risks, and guaranteeing that both exporters and importers meet contractual obligations. Essentially, trade finance is a type of working capital that provides businesses with funds to conduct business transactions. Through trade finance, businesses are able to bring in a third-party to take on risks of payment and supply, making transactions smoother and safer. ¹

For example, when a business receives an order from a buyer, trade finance can help cover the cost of acquiring the necessary inventory to meet the buyer’s order. This can ensure timely delivery of goods and solve cash flow problems that might arise from delayed payments.²

How trade finance works

The parties involved in a trade finance transaction can include exporters, importers, and financiers like banks, insurers, trade finance companies, etc. In international trade, there are two broad ways in which trade finance works: pre-shipment finance and post-shipment finance.

1. Pre-shipment finance

Pre-shipment finance helps exporters buy raw materials, manufacture, pack, and send out goods. It includes loans for packing, government receivables, and advance payments.

2. Post-shipment finance

Post-shipment finance provides loans to exporters after the goods are shipped or services are provided. This helps cover the money owed from sales. The loan is repaid when the export money comes in, with the exporter being responsible if there are issues.³

Here is a condensed explanation of the process exporters must follow to secure trade finance:

1. Trade finance application

The exporter approaches a financial institution such as a bank and asks for a trade finance solution. The exporter submits an application and a list of necessary documents to help lenders learn more about the company, the business plan, and how the funds will be used.

2. Evaluation by the lender

The lender undertakes a thorough assessment of the exporter’s application, including key financial information, operating market and sector, risks involved, etc.

4. Issuance of instrument

Based on their analysis, the financial institution will offer a loan payment to the exporter through a trade finance instrument. The conditions of the loan and the exporter and lender’s obligations will be outlined. Once both parties sign the document, the payment will be released as per the agreed-upon terms.⁴

Benefits of trade finance

Trade finance offers various advantages for both exporters and importers. Some of these are as follows:

Reduced risk:

Trade finance instruments reduce the risk of non-payment for exporters and the risk of receiving non-desirable goods for the importer.

Improved cash flow:

Trade financing speeds up transactions by providing upfront funds. This helps exporters ship on credit and boost their working capital. Importers benefit from extended payment periods which improves their cash flow.

Enhanced confidence:

Trade finance creates confidence and credibility between trading parties and promotes international trade dealings.

Access to new markets:

By managing risks like non-payment and non-delivery of desired goods, trade finance makes it possible for companies to confidently expand their operations into new foreign markets.⁵

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What are the types of trade financing

Trade finance includes various financial products that support the needs of international traders. Here are some types of trade financing:

Letters of credit (LCs):

A letter of credit is a bank-issued guarantee that a buyer will pay the seller for goods or services as long as terms in the LC are met.

Supply chain financing:

Supply chain financing allows companies to pay their suppliers sooner while giving buyers more time to settle payments without impacting their working capital.

Factoring:

Factoring is when a business sells its unpaid invoices at a discounted rate for an upfront payment. The factor then collects the invoice amount from the customer, improving cash flow for the business.

Discounting:

Discounting is similar to factoring but does not involve collection services. Businesses sell their invoices at a discount for immediate cash flow, allowing them to meet urgent financial needs.

Purchase order financing:

Purchase order financing involves a bank or financial institution providing funds to a business to pay its suppliers upfront. This reduces the risk associated with trade on credit and is useful for larger transactions.

E-commerce financing:

E-commerce financing supports online businesses by helping them finance inventory and related expenses, providing liquidity to cover the gap between purchasing goods from suppliers and collecting revenue from customers.⁶

How trade financing reduces risk

Trade finance helps minimize the following risks associated with international trade:

Payment risk:

Trade finance tools including letters of credit ensure that the buyer’s bank pays for the goods, provided the LC conditions are met. This way, the chances of not being paid are minimized.

Country risk:

Trade finance providers assess involved countries in terms of political and economic risk and come up with mechanisms to operate in high-risk countries.

Corporate risk:

Through a credit review, a trade finance provider can determine buyer’s ability to perform their obligations or the creditworthiness of the seller. This can help reduce the trade risk.⁷

What is the eligibility criteria for trade financing?

Generally, any firm that seeks to access trade finance has to meet certain eligibility requirements, which can vary depending on the financier and the type of trade finance product. Generally, the eligibility criteria will include the following:

Established business operations:

Most trade finance providers prefer to deal with companies that have a good trading history, and a sound financial background.

Confirmed purchase orders:

Typically, trade finance is in relation to confirmed purchase orders from genuine buyers, meaning that there is a real need for financing.

Creditworthiness:

To access trade finance, the business must prove its ability to repay the given trade finance facility through a credit check and evaluation of its balance sheet.⁸

What is the difference between trade finance and export finance?

Despite the frequent confusion between trade and export financing, there are a few key differences between the two:

Trade finance:

Trade finance is a general category of financial products that have been designed to facilitate imports and exports. It includes instruments like letters of credit, supply chain finance, and invoice financing which are used to facilitate global trade.

Export finance:

This is a subcategory of trade finance which only deals with the financing of goods and services for export. Export financing can include products such as export credit insurance and pre-export financing to help exporters finance their operations and produce goods for export.⁹

Conclusion

Trade finance is a fundamental aspect international trade that helps importers and exporters conduct efficient trade transactions and address cash flow issues. With trade finance, small businesses and e-commerce exporters can expand their operations and enter new markets with assurance. For additional support with international shipping or other aspects of e-commerce exports, exporters can leverage the tools and services offered by e-commerce export programs like Amazon Global Selling.

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Frequently Asked Questions

Who can use trade finance solutions?

Trade finance solutions can be useful to all types of businesses that are part of the international business community. Whether you’re an importer or exporter, trade finance helps manage cash flow, reduce risks, and handle large orders without straining your balance sheet.

Is trade finance a loan?

Trade financing is not like conventional borrowing. It comprises of different products and securities such as letters of credit, invoice financing, and supply chain financing, which help in trade transactions.

Who is involved in trade finance?

Trade finance involves several parties such as the exporter (seller), importer (buyer), trade finance provider (normally a bank or financial institution), and also other intermediaries like factoring companies and export credit agencies.

Published on August 13, 2024.

Sources:
1. https://www.investopedia.com/terms/t/tradefinance.asp
2. https://www.british-business-bank.co.uk/business-guidance/guidance-articles/finance/what-is-trade-finance-and-how-does-it-work
3. https://content.dgft.gov.in/Website/TF.pdf
4. https://www.tradefinanceglobal.com/trade-finance/trade-finance-process/
5. https://www.order.co/blog/finance/trade-finance/
6. https://www.order.co/blog/finance/trade-finance/#:~:text=Trade%20finance%20aims%20to%20reduce,Arranging%20for%20letters%20of%20credit
7. https://content.dgft.gov.in/Website/TF.pdf
8. https://www.tradefinanceglobal.com/trade-finance/trade-finance-process/
9. https://www.tradewindfinance.com/blog/2023/08/31/export-finance-vs-trade-finance/

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