Types of trade finance options for companies
It is no exaggeration to state that international trade and commerce form the backbone of the world’s economy. As we know, companies involved in international trade need a steady inflow of capital to sustain their operations. The various financing options in this industry support approximately 80 percent of the global trade. With effective ways to inject funds in their trading operations, companies can widen their scope to include their presence in all the lucrative markets. There are several ways by which companies can attain the finances required to carry out import and export operations. Some of the common trade financing options include:
Letter of credit (Letter of undertaking)
The letter of credit finance option, also known as a letter of undertaking (LOU), is beneficial for companies dealing with unfamiliar/new trade partners. It is adopted by companies involved in international trade. The process of LOU payment usually includes an issuing bank (importer’s bank) and a nominating bank (exporter’s bank). Initially, the importer creates a list of requirements for an impending purchase of goods. This list includes the following details:
- Bill of lading
- Packing list
- Commercial invoice
- Quantity and description of goods
- Other verification documents
Based on these requirements, the issuing bank creates a letter of credit. This letter is then sent to the nominating bank. When the goods’ delivery is made, the exporter’s bank gets the bill of lading (to notify the exporter about the successful delivery). The nominating bank verifies the other documents. The letter of credit ensures that the exporter receives his payment from the nominated bank. After this, the importer pays for the goods to the issuing bank. The issuing bank reimburses the nominated bank thereafter. Letters of credit provide a certain degree of financial security to exporters. LOUs commonly are of four types:
- A revocable letter of credit: The issuing bank can change/cancel the letter of credit at the buyer’s request without the seller’s consent.
- A Revolving letter of credit: It ‘revolves’ either in value or time. Such a letter of credit can be used for multiple shipments over longer periods.
- A standby letter of credit: It provides more flexibility to the exporter and importer. The issuing bank honours it when the importer is unable to pay the due amount on time.
- An Irrevocable letter of credit: It cannot be cancelled/modified without the exporter’s consent.
Factoring and forfaiting
Generally, companies adopt the factoring option, also known as invoice financing, to facilitate the domestic trading of goods. However, this option is applicable for international trade financing too. Factoring is useful for newer companies in any industry. In this process, companies receive cash from lenders (known as factors) against their account receivables. Companies raise funds in exchange for receivable accrued money from the sale of goods and services. With this option, companies can receive between 80 to 90 percent of their receivables’ monetary value. Accordingly, the factors pocket the remaining 10 to 20 percent. The factoring deals are made using financial instruments such as bills of exchange or promissory notes.
Factoring is useful for smaller companies in the international trade industry. While debt is often inevitable, especially for newer companies, most businesses would prefer to attain finances without borrowing money from lenders. That’s primarily because excessive debt can drive a company out of business and most lenders would also be wary of lending to new businesses that do not possess assets to pledge as collateral. Thus, factoring is a helpful option for such companies.
Forfaiting shares similarities with factoring because both financing options involve the sale of receivables to generate finances. However, the maturity period for forfaiting ranges from one to three years from the date of receivables’ sale (The maturity period for factoring can be up to 90 days only). Moreover, borrowing companies get a full 100 percent monetary return in exchange for their trade receivables. Lastly, the buyer pays the forfaiting costs (in factoring, the seller covers the expenses).
Open accounts for future trade payments
This is a viable financing option for prolific importers of goods. This avenue enables importers to pay for purchased goods later (usually within 30, 60 or 90 days). Sellers need to trust their buyers to make the payments without fail. This payment avenue gives unprecedented powers to the importers. The importers can sell the goods immediately after purchasing them. This can boost the cash flow generation for them.
This ‘buy now, pay later’ option is inherently risky for exporters. Other than maintaining long-term relations with certain importers, the payment option is not lucrative for sellers. To offset this, some countries have made it mandatory for sellers to limit their exporting until the complete payment for goods has been received. Such countries have stringent export laws in place to safeguard the sellers’ finances.
Consignments are another variation of the open account financing method. The consignment method is used for the trade of heavy and expensive machinery as well as rare and exclusive artwork.
Cash in advance
For major exporters of goods, this payment option is the safest of them all. Under this financing avenue, buyers are obligated to make complete payment for the goods before receiving their delivery. Businesses such as Amazon follow this financing model for their consumers, who must pay immediately on making an order and then receive the goods later. However, such companies also offer contingency options for the consumers in the form of full refunds if the deliveries are not made or the delivered products are damaged. Unlike the open account financing option, this avenue is nearly risk-free for exporters and the opposite for importers.
Having partnered with hundreds of international traders, we at Freightwalla understand that relying exclusively on your buyers for timely payments and funds to sustain operations can be somewhat of a gamble. That’s why apart from our digital freight forwarding services, we also offer solutions for you to obtain financing for your international trade operations. You can visit our website to receive more information about our services.