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Types of Trade Finance

Types of Trade Finance

Reviewing the global trade and export finance market since 1983, trade finance helps trade transactions feasible for banks and companies. Trade finance constitutes of instruments and products, which companies use for international trade and commerce; thereby making it easy for importers and exporters to make business transactions for trade.

To bring down the payment risk and the supply risks during international trade, trade finance introduces third party to business transactions. Through trade finance, exporters get receivables or payments, as per the agreement and the importers receive credits to fulfill the trade order.

The key parties involved in trade finance are the banks, companies, exporters, importers, insurers, credit agencies and service providers.

While general financing usually indicate financial necessity in cases where buyers lack funds or liquidity, trade finance is mostly used to provide protection against the unique inherent international trade risks – like currency fluctuation, political instability, non-payment issues, credit-worthiness of any party involved in the trade and others.

Import Finance

Majorly trade finance is categorised as import finance and export finance to facilitate various trade related activities.

Bridging the gap between receiving the good and transferring the payment, import finance refers to a short-term finance provided by a third party to import goods into a country. With the escalated need for trade finance, amid subsequent increase in international trade, import finance becomes a key mode of financing while a business face difficulties in trading overseas alone.

Key requirements that a financier ask for in import finance are:

  • Audited financial statement of the beneficiary
  • Entire business plan
  • Forecast of expected financial cash-flow
  • Credit reports
  • Details of the company’s directors
  • Details on the company’s liabilities

Import finance can be of several types, including:

  • Usance / Standby letter of credit – A letter of credit (LC) or the credit letter is issued by a financial institution to guarantee the on-time payment from a buyer to a seller. In a transaction with a usance LC the payment from a buyer is allowed to be deferred, giving the buyer more time to inspect or sell the goods. On the other hand, if standby LC is applied in a transaction, it guarantees payment; thereby preventing risk of any financial losses.
  • Bank guarantees – Bank guarantees certifies the creditworthiness of a buyer, and ensures fulfillment of financial obligations of buyers, in case they fail to do so.
  • Invoice finance – Invoice finance is a method of financing in which a third party – invoice finance firm – allows access to funds earlier than the payments terms on the transaction.
  • Asset-backed Facilities – In asset-backed finance, businesses get secured with a loan against the collateral of the customer.

Export Finance

The financial support extended by institutions – like banks – to businesses for transactions during overseas shipment of goods refers to the export finance. Export finance is the credit facility or technique of payment at the pre-shipment and post-shipment stages and helps making financial process of purchasing, processing manufacturing or packing of goods more comprehensible.

This type of trade finance is provided by banks which are members of the Foreign Exchange Dealers Association (FEDA) and the refinance facilities to the commercial banks in India are issued by the Reserve Bank of India (RBI) and the Industrial Development Bank of India (IDBI).

Export finance can be categorized into:

  • Pre-shipment finance – Pre-shipment finance is the finance required by an exporter before the shipment of goods. Pre-shipment finance provides the exporter with working capital required for funding of wages, production cost, buying raw materials, processing and converting into finished goods and packaging. Pre-shipment finance is extended under the concessional rates of interest at 7.5 per cent, to a maximum period of six months.
  • Post-shipment finance - Post-shipment finance refers to the finance extended after the shipment of goods. In this type of export finance, the financer advances the payment, post shipment, to gain liquidity between shipping the goods and receiving payment. It mostly bridges the gap between the date of extending the credits after the shipment of goods to the date of realization of the export proceeds. Post-shipment finance is extended under the concessional rates of interest at 8.65 per cent, to a maximum period of six months.
  • Supply chain – The technology-based financing procedure which links various parties in a transaction – such as buyer, seller, financer – for lower cost and better efficiency, is known as Supply chain finance or supplier finance or reverse factoring. It optimizes working capital for both the buyer and the seller by providing short-term credits.

Trade Credit

In trade credit a bank-backed bill, guaranteed by the buyer’s bank is issued. Being one of the cheapest and easiest arrangements of trade financing, trade credit relies on the mutual trust between the buyer and the seller, and is mostly opted in cases where there are less knowledge on the buyer’s credit-worthiness or if the two parties are not well-known to each other.

Cash Advances

Cash advance – another trade finance based on trust – is an advance payment of funds before the shipment of goods, to help the exporter in manufacturing and production of goods following an order.

Receivables Discounting

Commercial and financial documents, sold by new finance houses and marketplaces, at discounted rates in exchange for immediate payment are called receivables. The comparatively high rates of discounts are calculated considering the risk of default, the seller’s credit-worthiness and depending on whether the transaction is domestic or international. Receivable discounting often turns out to be costly for the Small and medium-sized enterprises (SMEs).

Term Loans

One the most sustainable types of trade finance is by funding long term debts – which may include loans, commercial mortgages and overdraft facilities, mostly with a backing of security or guarantee. However, in global trade, keeping overseas business owner’s assets as security can be problematic, considering the different ownership regulations in different countries.

Leasing and Asset-backed Finance

Funding received against collaterals – machineries, vehicles, equipment – kept as securities, refers to Leasing. Preferred for tax treatment in most markets, Asset finance allows SMEs to buy asset over a period of time, with minimum concern of maintenance. This type of trade finance includes finance leases, hire purchase and operating leases.