Mastering trade finance: Credit, negotiations, & risk

International trade creates risk for trading parties relating to uncertainty over the timing of payments between exporters and importers.

For instance, an exporter often has a cash flow shortfall when it provides trade credit to an importer.

This is because payment is not received until some weeks or months after the goods have been shipped, and during this time, the exporter must pay for any outgoings, such as supplier costs and staff salaries.

On the other hand, if an importer makes payment when the goods are shipped, then it is likely to experience the cash flow shortfall rather than the exporter.

This is because the goods may not be received for some weeks or months after payment has been made, and during this time, the importer must pay for any outgoings, such as staff salaries.

Therefore, the provision of trade credit can create a financing need for both exporters and importers.

Thankfully, there are many forms of trade finance available, including bank facilities, invoice discounting, factoring, forfaiting, and supply chain finance. These can help finance transactions that otherwise would not be possible.

Finally, to help mitigate the risk for exporters, export credit insurance can be provided by commercial insurers and export credit agencies.

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Financing trade credit

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A seller that provides trade credit to a buyer may need to borrow to finance its outgoings until it receives payment.

The longer the period of credit given to the buyer; the larger the financing need is likely to be.

Take the example of a seller that delivers goods to the value of USD 1.5 million to a buyer on 3-month credit terms.

During this 3-month period, the seller must continue to pay its suppliers and monthly overheads.

Due to its ongoing expenses, by the end of month 1, its net cash flow is a negative USD 300,000…

… while in month 2, another USD 400,000 in expenses brings its net cash flow to a negative USD 700,000.

In month 3, it has further expenses of USD 600,000, which would have brought its net cash flow to a negative USD 1.3 million but for its outstanding invoices of USD 1.5 million being paid.

Although by the end of month 3, the seller is cash-positive…

…it faces a cash shortfall of up to USD 1.3 million depending on when it receives payment in that month.

To meet this shortfall, the seller could use any existing credit facilities or raise new finance.

Alternatively, it could seek to reduce or eliminate the shortfall by:

• Offering the buyer a discount for payment on delivery
• Shortening the period of credit, or
• Increasing the period of trade credit it obtains from its suppliers

Let’s look at the first option, where the seller offers the buyer a discount for payment on delivery.

For example, let’s assume the seller offers the buyer a discount of USD 100,000 for payment on delivery.

So the buyer agrees to pay, on delivery, a discounted price of USD 1.4 million in month 1, instead of USD 1.5 million in month 3 …

… the seller’s cash shortfall would be eliminated in month 1, although the seller would receive USD 100,000 less and the buyer might need to borrow to make the payment on delivery.

Now, let’s look at the second option, where the seller offers the buyer a discount in return for a shorter period of credit.

For example, let’s assume the seller offers the buyer a discount of USD 50,000 for paying the outstanding invoices in month 2 as opposed to month 3.

So the buyer pays a discounted price of USD 1.45 million in month 2, instead of USD 1.5 million in month 3 …

… the seller’s cash shortfall would be eliminated in month 2, although the seller would receive USD 50,000 less and the buyer might need to borrow to make the payment one month sooner.

Now, let’s look at the third option, where the suppliers to the seller increase the trade credit.

For example, let’s assume the suppliers agree one month longer terms in exchange for a small price increase of 5%,…

… the cash shortfall is much smaller and for a shorter time period.

The fundamental principles underlying these examples are the same where the seller is an exporter and the buyer an importer in another country, although there are some added dimensions to consider for such cross-border trade.

Domestic vs. cross-border trade credit

An exporter considering whether to provide trade credit to an importer and the terms on which to do so must be aware of a range of factors.

Some of these factors are distinct from those applicable to domestic sales.

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Timeframe

The period from shipment until payment may be a lot longer for international rather than domestic trade. This is particularly true where payment is agreed on D/A (documents against acceptance) terms, and the credit period only starts when the bill of exchange is accepted.

Credit risk

The risk of nonpayment can often be higher for international transactions, especially where the exporter and importer have not conducted business previously.

Country risk

Country events – such as foreign currency not being made available for non-essential imports – may prevent an importer from making payment.

FX risk

Exporters and importers are subject to exchange rate risk if invoices are denominated in nonlocal currencies.

Disputes & delays

Disputes and delays can arise and may be difficult to deal with due to geographical and timezone differences, language barriers, and differing customs and practices.

Risk mitigation

Insurance cover, for example, is available to cover credit and country risks.

Financing options

There is a range of distinct finance options available for exporters and – to a lesser degree – importers.

Cross-border trade negotiations

Given these factors, it is not surprising that negotiations between exporters and importers can take a lot longer to conclude than domestic negotiations, particularly for larger and more complex orders.

An exporter, for instance, must consider potential financing options and costs (if finance is required) and any risk mitigants available, and then try to factor this into the commercial terms agreed with the importer. But if the exporter has little or no bargaining power, it must decide whether to accept the terms offered by the importer or risk losing an order.

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Export vs. import finance

While it might be thought that export and import finance are quite similar in nature – or even opposite ends of the same finance spectrum – this is not the case.

Export finance

In situations where finance is provided to an exporter, there is an underlying trade transaction that provides an identifiable source of repayment – the funds due from the importer.

This means that, provided it is possible to link the provision of finance or assign credit insurance cover to the receipt of funds from the importer, a range of finance options is likely to be available to the exporter.

Import finance

By contrast, it is unlikely that there would be a readily identifiable source of payment in situations where finance is provided to an importer.

The position may, however, be different if:

• The importer is also an exporter
• The lender can retain title to the goods (such as through a trust receipt)
• A guarantor is available

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Intuition Know-How, the world’s premier digital learning solution for finance professionals, offers a comprehensive course on Trade Finance. More details can be found below.

If you would like to speak to a member of our team about gaining access to this course, please fill in the form.

Trade transactions have been taking place for centuries and a number of the practices that support the smooth execution of such transactions, such as the use of drafts and bills of lading, have been around for a long time.

In recent decades, however, transactions have grown in size and complexity and both the value and volume of overall trade has increased substantially. Further, new forms of transportation – such as containerization – have emerged and proliferated. Meanwhile, the use of electronic documentation has become more common and FinTech firms are starting to make inroads into what has traditionally been a heavily paper-based environment.

In the context of these and other developments, this course provides a detailed description of all aspects of trade finance. It covers topics such as:

• The need for trade finance products and the different types of product provider
• The main methods of payment used for trade transactions
• The use of open account terms in international trade
• The role of documentary collections in facilitating payment for trade transactions
• The various features of letters of credit (L/Cs), the lifecycle of a typical L/C, and the parties involved in that lifecycle
• The different types of bond/guarantee provided by banks and other guarantors to their customers
• The different forms of import and export finance available to buyers and sellers involved in international trade
• The role of export credit agencies (ECAs) in facilitating trade transactions
• The concept of structured trade finance and how it differs from traditional trade finance
• The importance of trade documentation and the role of the various rules/guidelines, such as UCP 600 and Incoterms, published by the International Chamber of Commerce (ICC)