The Importance of Trade Finance

Trade finance allows companies to trade both nationally and internationally. It bridges the payment gap between the seller and the buyer.  The choice of trade finance that a company chooses depends generally to whom they are selling to, the country they are in, the product/service they are selling, the cost, the payment history of the buyer and the amount of risk a company is willing and able to take.

 Companies that have long standing relationships and that have built up years of trust are able to pay on credit.  Trade credit allows companies the time to distribute and hopefully sell the product, Trade credit can vary in many countries and this can cause many SMEs a real issue with cash flow and liquidity.  

The challenge for any seller but in particular for SMEs is how to get a sale and ensure payment in the quickest possible time.  However, the buyer also has his/her issues as payment before they have sold the products causes them a cash flow problem.

 In a sale, there are always at least 2 participants (often more) and so there is a conflict despite one party wanting to sell and the other party wanting to buy.  Trade finance bridges the finance gap allowing a transaction to take place.

 Deciding on what trade finance you will offer depends on the company you are dealing with, the industry, the country and the companies own finances and ability to take on risk. For the seller, cash in advance is the least risky, however, it puts immense pressure on the seller and this can mean that the sale will not take place.  So what are the alternatives that reduce the risk for the seller and give the buyer some leeway with cash flow?  The most frequently used method of trade finance, when trade credit is not being offered is a Letter of Credit (of which there are different types), whilst this does mean that the seller has a high percentage chance of being paid as a bank has guaranteed the funds, it is not without its challenges and risk as the bank can refuse to pay if there are any divergences for contract and documents received and this can give the buyer an opportunity to re-negotiate the contract in order for the seller to get paid. Both the buyer and seller incur costs for a letter of credit and this can be one of the reasons to look at other options of payment.

 Cash against documents (document collection) is also a widely used option.Its purpose is for the vendor to get the amount owed by a customer from a bank against delivery of documents (invoices, bill of lading...etc.).

 With Cash against documents, the bank is not guaranteeing the payment and so this increases the risk of non payment, however, there is a very clear paper trail, if a company needs to resort to legal proceedings to get paid. There are also certain precautions that you can to do to reduce the risk of non–payment.  The goods are released either on acceptance (of the goods) or payment (depending on the contract). There are many advantages of cash against document, e.g. cost is low but there are also disadvantages e.g. non-payment.

Getting the correct trade finance for your transaction can be the difference to getting paid to not getting paid.  For example, if you start working with a new partner, who is now your main distributor, document collection may be a good choice as you have done a credit check on the company and there is a distribution contract in place which implies that there will be an ongoing relationship between the two companies. In this scenario, the seller might consider document collection a better option as the risk is possible low of non-payment as hopefully there will be a long term relationship and the costs are considerably lower than a letter of credit.

 A seller needs to weigh up and analyse his/her risk and this will help them determine what form of trade finance they should use. Understanding the whole picture – your own finances, the buyer, the products, the destined country and the relationship will help you choose the best trade finance for your transaction.

If you’d like to discuss exporting and trade finance with OpenVentures contacts us sales@openventuresconsulting.com.