Trade Finance Meaning
Trade Finance is funding of trade transactions (both domestic and international) and it can be conducted in the presence of both buyer and seller of products and services and it can be facilitated with the help of various intermediaries like banking institutions and financial institutions.
Trade finance lets companies import and export their products and services with lots of ease and convenience. It signifies the financial instruments that an entity takes into its use to facilitate foreign trade and commerce. Trade financing not just includes all the facilities with respect to lending, but also includes issuing of LCs (Letters of CreditLetters Of CreditA letter of credit is a payment mechanism in which the issuer's bank gives an economic guarantee to the exporter for the agreed payment amount if the buyer defaults. In international trade, buyers employ LC to reduce credit risk.), export factoring, forfeiting, export credits, and insurance as well.
How does it Work?
Trade finance is one of the best convenient ways for the management of credit facilities. With this, the cash required can be accessed immediately instead of the need to wait for the buyers’ payments to pour in and usually provides leverage of 120 days to pay the cashback.
Types of Trade Finance
Following are the types –
- Trade Credit – Trade credit is a trust that lies in between a buyer and a seller with respect to payments that are proposed by the former to be paid at a date later to the latter.
- Cash Advances – Cash advances are a payment of unsecured funds to exporting companies before the goods are being shipped.
- Receivables Discounting – Receivables are financial documents that are sold at highly discounted prices for immediate payment.
- Term Loans – Long term debtsLong Term DebtsLong-term debt is the debt taken by the company that gets due or is payable after one year on the date of the balance sheet. It is recorded on the liabilities side of the company's balance sheet as the non-current liability. such as commercial mortgages, loans, overdraft facilities are more sustainable options for funding compared to asset-backed financing.
- Leasing & Asset-backed Finance – Leasing finance is all about borrowing several funds against valuable assets like vehicles, machinery, etc. Asset-backed financingAsset-backed FinancingAsset financing is defined as a loan taken out by an organization using balance sheet assets as collateral, such as land and buildings, vehicles, machinery, trade receivables, and short-term investments. The asset's value is divided into regular payment intervals of the asset's unpaid portion plus interest. allows companies to buy assets and worry less about their maintenance. Asset-backed financing provides tax benefits too.
- Other Types – Seed funding, crowdfundingCrowdfundingCrowdfunding is a method through which the business can raise capital from many individuals beyond friends, family, relatives, and customers by posting the project details on the websites and other social media platforms. It does not involve banks and any other financial institutions., angel investment, VC (venture capital) funding, floatation cost, etc. are the other types.
Methods of Payment used in Trade Finance
- Advance payment – In this type of payment method, the buyer clears 30 percent of the payment to the supplier while ordering and the rest 70 percent when the goods and services are shipped to him.
- L/C or letter of Credit – Letter of credit or L/C gives the seller of the goods and services two guarantees, confirming the buyer will initiate the payment. The first guarantee would be received from the buyer’s bank, while the second guarantee shall be received from the sellers’ bank.
- Bills for Collection – Bills of exchangeBills Of ExchangeBills of exchange are negotiable instruments that contain an order to pay a certain amount to a particular person within a stipulated period of time. The bill of exchange is issued by the creditor to the debtor when the debtor owes money for goods or services. are a type of payment method that ensures that the export has trust with respect to the collection of payment to his or her remitting bank.
- Open Account – This type of payment method is used by partners of a business who have huge trust in each other. The business partners will need to have a separate bank account for this purpose with the correspondent banks.
How does Trade Finance Reduce Risk?
There are various types of risks associated with trade financing.
- Product Risks
- Manufacturing Risks
- Transport Risks
- Currency Risks
Trade finance helps in reducing the delay of the shipment of goods in a manner that these are received and inspected on time by the receiver which builds trust between the buyers and the sellers and minimizes numerous risks like delay in payments, issues in the exchange rate, loss or theft of products and services that could arise out of such complicated transactions. With this, various types of risks like product risks, manufacturing risks, transport risks, and currency risks can be mitigated or adequately dealt with all together.
It creates tonnes of equal opportunities for everyone. Trade financing is a mechanism through which the time-lagged between the shipment of a product or commodity from one market to its arrival in another market is efficiently bridged. Trade finance helps in the mitigation of numerous risks like loss or theft of products, also known as product risks, manufacturing risks, transport risks, exchange rate risksExchange Rate RisksExchange Rate Risk is the risk of loss the company bears when the transaction is denominated in a currency other than the company operates. It is a risk that occurs due to a change in the relative values of currencies. (currency risks), etc. By mitigating the probabilities of such risks, the buyers and sellers can trade freely without needing to worry about losses.
Trade finance also helps in establishing a profound and long-term relationship between a buyer and a seller as it takes charge of laying the foundation of mutual trust and understanding. It even eliminates the possibility of delay in payments as well as the supply of goods and services, which ultimately help in the development of a healthy and strong relationship between buyer and seller. It is a convenient way of arranging short-term finances, and it also helps a business focus on various types of growth activities. It allows securing finance against assets and insurance policy.
One of the reasons why trade finance is highly discouraged could be the fact that it can turn out to be very expensive if, in any case, the payments are delayed or are failed to be processed on time. Another reason could be the fact that it is certainly based upon the fact of having a decent track record in terms of repayments and business operationsBusiness OperationsBusiness operations refer to all those activities that the employees undertake within an organizational setup daily to produce goods and services for accomplishing the company's goals like profit generation., and this makes the same lower accessible for newly formed companies.
Trade Finance is a type of short-term creditType Of Short-term CreditThere are two types of credit facilities: short-term and long-term. A short-term credit facility is used to meet an organization's working capital needs, such as paying off creditors and bills. A long-term credit facility, on the other hand, is utilized to meet capital expenditure requirements, which are frequently financed by banks, private placements, and banks. that is used by entities that are involved in the export and import of products and services. It makes securing short-term finance easy if at all, the company has a good trading record, and the transactions here are highly secured against assets and, in some cases, backed up by insurance policies. Trade finance also helps in dealing with risks like manufacturing risks, product risks, transport risks, and exchange rate risks.
This article has been a guide to Trade Finance and its Meaning. Here we discuss how does trade finance work along with its types, methods, benefits, and drawbacks. You may also have a look at the following articles –