4 Key facts business leaders need to know about trade finance

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With the international development of trade forms, awareness of risks involved has increased. To ease this uncertainty and maintain financial flow for trade, financial institutions have adapted and enhanced several payment instruments which can be used locally or internationally. Trade finance is a key catalyst, primarily for small and medium enterprises because it gives them a chance to provide better conditions for customers and match big players in the market. The World Trade Organization estimates that trade finance has contributed as many as some 80 to 90 percent to world transactions. Whether you are a private entrepreneur or ahead of a large company, you need to know a few facts about trade finance. In this way, you can use its benefits in line with the needs of your company and improve your business.

1. When and how to use trade finance

Doing business on the international level entails several risks. Often the risks that can’t be controlled include non-payment issues, currency fluctuations, and/or creditworthiness. In order to facilitate the complex process of international trade, the buyer and the seller often include a third party in their relationship. In this case, the bank, insurers, or export credit agencies assume a part of the risk to themselves for a certain fee. There are many instruments available, and your choice depends on several factors, such as the size of the company, the stage of development the company is in, the financing costs and whether the macroeconomic environment is stable. It is also important to consider the nature of the risk which the exporter would like to protect themselves from.

2. What are all the options available to you?

It is extremely important to distinguish the most common use of trade finance instruments and their characteristics.

Bank guarantee – one of the highest quality instruments for securing payments. They focus on the speed and efficiency of implementation. The bank guarantees will be paid by the debtor or obligations that will be fulfilled as stipulated in the contract to a third party. Otherwise, the third party will collect the claim from the bank, while the bank will later settle the obligations towards the debtor.

Letter of credit – commonly used because it protects both the buyer and the seller of goods. Therefore, it is ideal when the transaction takes place among unknown contractors. With the letter of credit, the collection of receivables is conditioned by submission of the documents provided by the letter of credit. If the debtor does not provide coverage, the buyer’s bank will do so.

Export credit – ensures the stability of exporters’ cash flow. The exporter usually approves it to provide a sufficient amount of money for the time they send the goods abroad until they collect those goods.

trade finance instrument

3. Factoring and forfeiting – similarities and differences

Factoring and forfeiting are unique forms of financing based on the purchase of receivables.

In factoring, an enterprise sells its receivables to a third party, a bank or another financial institution, called a factor. The subject of factoring is usually any future or already due receivable. They can sell it in whole or in parts. This way, the exporter immediately receives money from receivables with fewer commissions. Factoring short-term receivables is extremely popular among small and medium-sized (SME) companies. With the help of this trade finance instrument, SMEs at the same time provide liquidity and competitive advantage based on the possibility of a longer repayment period that they offer to their customers. Also, factoring does not increase the debt of the customer and does not diminish their credit potential.

The subject of forfeiting, unlike factoring, are long-term receivables. Also, in this form of trade finance, the purchase of receivables by a third party, a forfeiter, is performed for a fee and without the right to recourse. Various instruments confirm trade debt, such as a bill of exchange, a letter of credit with deferred payment, or another security.

4. Choose wisely – gain an advantage

A dynamic and well-developed economic environment has made trade finance one of the principal ways to maintain cash flow and reduce risk. Effective management of funding sources is one of the primary tasks of managers and the basis for gaining a competitive advantage in the market. Due to all reasons listed above, trade finance is in the same rank of importance as technological development and product quality.

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