What is a Trust Receipt?
Trust Receipt is short term finance in the nature of promissory note to the bank where the loan availed would be repaid on sale of goods (local or export) to the customer.
Explanation
- Usually, companies may not have adequate cash and cash equivalents for them to purchase inventory from a vendor to effect sale But may have sale orders from customers. In these cases, they approach the banker for short term credit in the nature of trust receipt. The banker would make payment for the goods to the foreign exporter or the domestic seller. Using the inventory purchased from the vendor, the company can make a further sale to the customer, on realizing the receivable, the loan availed from the bank is repaid with nominal interest rateNominal Interest RateNominal Interest rate refers to the interest rate without the adjustment of inflation. It is a short term interest rate which is used by the central banks to issue loans.read more.
- The borrower (i.e) the person who approached the bank for the trust receipt must have adequate segregation of the goods which have been obtained. The periodical report is also issued to the banker on the basis of a trust receipt agreement.
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For eg:
Source: Trust Receipt (wallstreetmojo.com)
Format of Trust Receipt
These are used throughout the world with no uniform format. In other words, this issued by a bank in the UK may not be the same as practiced in the USA.
The basic requirements are as follows:
- Date of the Trust Receipt
- Attachment of Sale order received
- Nature of the goods purchased (PO attached if obtained)
- Approvals obtained from the concerned authorities (If import)
- The Bank account details of the foreign exporter
- Other terms as required by the bank
How does Trust Receipt Work?
The process practically is quite complicated especially in case of import or export transactions as the provisions of the local customs act and the rules (if any) made thereunder are also to comply.
The basic process is as follows:
- The customer approaches a bank for the want of trust receipt by filling the required forms and completing the necessary process.
- The bank on being satisfied with the documentation appoints the customer as its agent to purchase the good required by him on behalf of the bank.
- On receipt of goods, the bank pays the purchase consideration to the supplier of goods within the timelines agreed.
- The Payment is made only to the bank account as mentioned in the trust receipt document.
- The goods obtained are segregated and stored in the warehouse of the borrower until sold.
- The Bank is intimated on a periodic basis about the closing balance of the good and its condition.
- The purchase consideration realized when sold is first used to settle the trust receipt’s principal and interest.
How is Trade Receipt different from the Letter of Credit?
So the next question is, How is trade credit different from the letter of credit?
- A letter of credit is a guarantee given to the foreign party by the local banker for payment of transactions’ consideration. It is not an instrument whereby the amount is paid by the bank and then collected from the borrower as in case of a trust receipt. In international transactions, the parties may not know each other.
- In these cases, the foreign vendor is not protected from the risk of default of his overseas customer. The vendor hence would want the buyer to give him a guarantee from his banker, stating that the bank would be liable to pay his consideration if customer defaults. The bank for this purpose would charge a commission from the customer for guarantee and not interest in case of trust receipt.
- In other words, in trade credit, the bank acts as the principal and the borrower is its’ agent. Whereas in the letter of credit, the bank just guarantees the payment to the foreign vendor and is liable only if the local customer defaults. Hence, Bank has the first charge in case of a letter of credit but the second charge in case of trust receipt.
So, the first and initial step is to ensure that the borrower has the documents in place to avail the trust credit, therefore the basic prerequisites would be:
- A bill of exchangeBill 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.read more (BOE) accepted by the buyer (A sale order is mere intention to buy, but BOE is acceptance to pay!)
- Invoice if already raised on the buyer
- Approval of customs authorities (if obtained – in case of exports)
Also, the above are general and are common across countries. The banks based on local laws make seek for additional documents.
Advantages
#1 – Easy Source of Finance
Usually, banks do not hesitate to give trust credit. This is because it is certain that the money would be repaid with interest once the goods are sold. It is a win-win situation to both the bank and the borrower since the bank gets money in the form of interest and the company earns money without having to initially invest.
#2 – Instant Liquidity
The cash otherwise available can be used for other working capital and investment purpose. This enables the company for effective treasury management.
Disadvantages
#1 – Excessive Control
Banks lay a lot of conditions on the customer. Few conditions are:
- To maintain the inventory pertaining to trust credit separately
- Maintain and issue reports to the bank on a periodic basis.
- The clause that “bank may conduct a stock audit if required”
- Cost constraint
The company may incur additional costs in terms of interest and to comply with the banks’ other conditions. A cost-benefit analysisCost-benefit AnalysisCost-benefit analysis is the technique used by the companies to arrive at a critical decision after working out the potential returns of a particular action and considering its overall costs. Some of these models include Net Present Value, Benefit-Cost Ratio etc.read more of this extant is to be conducted.
#2 – Excessive Documentation
You do not get a trusted credit unless the minimum of the above documents is submitted. Practically it is not possible to get customs clearance for export of goods to the customer without actually manufacturing the good.
(Note: you first buy the good and then process for sales)
Conclusion
Hence, The cheapest source of finance with a comparably flexible maturity period is trust receipt. The source can be selected with requisite cost-benefit analysis and by submitting requisite documents.
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