Updated: Jul 14
The term, “Trade Finance” is often used loosely and creates some confusion as clients do not always understand the essentials of what is included. With this blog we hope to simplify the meaning and purpose of Trade Finance. Please note that similar principles will apply to domestic trade.
According to Trade Finance Global (TFG), Trade finance accounts for 3% of global trade, worth some USD 3 trillion annually. In its simplest form it is the funding of trade in a company’s business cycle, whether it be for goods, services or commodities; a variety of financial instruments are used to structure this, under the umbrella term “trade finance”. These include documentary Letters of Credit and Foreign Bills for Collection, export finance and finance by credit agencies, receivable and invoice finance, as well as bank guarantees.
One of the key global contributors of economic growth amongst both developed and developing countries, is the ability for a country to import and export goods and services. It has been said that Importing and Exporting are two sides of the same coin as both supply customers with products manufactured outside their respective countries. A country’s ability to pay foreign currency for much needed raw materials and other cost-effective goods is significantly enhanced by the receipt of foreign currency for exported goods and services. It stands to reason that a country with healthy exports will also find that the status of their Balance of Payments Account (BOP) will be more positive than countries with low exports.
In most countries the exchange of goods and services with other nations of the world represents a significant share of gross domestic product (GDP). Surprisingly, did you know that In South Africa, global trade accounts for more than 60% of GDP?!
Whist it is impossible to unpack the entire Trade Finance process and considerations in one blog, we are going to provide some basic information and definitions regarding the topic in layman’s terms, as follows:
Working Capital Whist the working capital cycle of companies differ depending on if they are a manufacturing, trading or a services company, the ability to maintain a healthy and positive cash management position in a business is of utmost importance. The principle of “Money-in, Money-out” resonates with me when trying to make sense of the working capital principle in its simplest form. This must go hand in hand with a company’s cash management process where surplus short-term funds are wisely invested in easily accessible investment accounts and short-term shortfalls are financed using the most cost-effective finance options available.
These would include receiving extended payment terms from suppliers and providing extended payment terms to clients. Most companies should be able to finance the normal growth experienced in the company by managing the principle of “Money-in, Money-out” within a pre-determined cash flow management framework defined within the company. It is prudent to always calculate the cost of accepting extended payment terms from clients, in many cases this is not done, and companies could end up paying more than what they should for this finance method. For example, if an importer is not charged for 1-month extended payment terms, but receives a 2.5% discount for upfront payment, this will relate to a 30% per annum interest charge for the 1-month extended payment terms, meaning that local overdraft type financing could work out much cheaper. It is the writer’s view that most well run companies will be able to cater for all their normal trade requirements in the working capital finance at relatively low interest rates.
Trade Finance is by nature more expensive and should only be used to support large transactions and new growth opportunities. A basic overdraft facility remains the cheapest cost of financing a company’s working capital and trade requirements!
Global Trade Cycle - Pre/Post Shipment Finance Why is this important to consider? It is important for banks/financiers to understand the stage of the cycle that they are financing. During the process of sourcing products/services, the import finance cycle starts when the purchase order has been accepted by the importer and a pro-forma invoice has been issued. This can be referred to as the Pre-Shipment finance period, as in may cases a full or part advance payment is required by the manufacturer/supplier in the foreign country.
Similarly, the export pre-shipment finance period starts when the order has been received but the exporter has agreed to payment terms on, or after shipment. Post shipment finance occurs when goods have been shipped and delivered and the importer has obtained extended credit terms (normally from 30 – 120 days) with agreement from the exporter. During the pre-shipment stage of financing there will be performance risk in addition to the financial risk associated with the transaction and it is crucial to understand all these risk from a finance point of view.
Payment Methods The correct payment method to be used is a major consideration when dealing in Global Trade! Depending on the sovereign and commercial risk of the importer and its country, the exporter will evaluate the payment risk and will call for a payment method to mitigate the associated risk of payment of the importer and its country’s ability to provide foreign currency to facilitate payment. In general, developing countries with fragile economies, governed by complex legal systems would require trading partners to operate with caution. To facilitate trade under different conditions, there are various payment methods that can be used to mitigate any potential payment risk presented by the importer and its country.
These payment methods include: Advance payments, Letters of Credit, Foreign Bills for Collection and Bank Guarantees. These payment methods are facilitated by banks in both the Importer and exporter countries and are highly technical and specialised. Trade payment methods are governed by the International Chamber of Commerce (ICC) based in Geneva, carrying out the role of the institutional representative of more than 45 million companies/banks in over 100 countries. ICC plays a vital role in scaling widespread action on Sustainable Development Goals and has a long history of formulating the voluntary rules by which business is conducted every day – from internationally recognised Incoterms® rules to the UCP 600 Uniform Customs and Practice for Documentary Credit that are widely used in international finance.
Some of the payment methods mentioned above also provide the basis for banks providing Trade Finance on a “without-recourse” basis to clients.
Are clients able to raise finance in any currency? The most logical funding option for South African importers/exporters is to use local currency (ZAR) as the base for their funding requirements. The size and quality of a company’s balance sheet will determine the ability to obtain finance from banks and other service providers. There are various types of finance available in South Africa, including the overdraft facility, money market facilities (call loans etc) and term loans. As mentioned, most suppliers will also be able to provide extended payment terms, albeit at a cost.
Yes, clients can consider Foreign Currency as the base to a finance arrangement. When considering foreign currency as the base for finance it is imperative that exposures are mitigated by adequately hedging any open foreign exchange positions. It is wise not to be misled by perceived lower interest rates offered in Foreign Currency loans, as there is a cost attached to hedging foreign loan exposures.
Trade Finance transacted in ZAR will be based on the prevailing prime rate and will have a risk premium added to reflect the risk to the financier, and usually represents a direct reflection of a company’s financial position. Similarly, Foreign Currency loans will be based on LIBOR (a benchmark rate at which global banks lend to one another in the international interbank market for short-term loans), plus a risk premium.
Calculating the cost of finance Is it very technical to calculate the cost of trade finance? Calculating the cost of trade finance is not “rocket-science” due to the short-term nature of the underlying loans. Trade Finance loans are typically extended for 30 – 120 days but all periods up to 360 days are regarded as short-term Trade Finance. Interest in the financial world is quoted per-month or per-quarter but should always be converted to an annual rate to enable proper comparison to the benchmark prime rate in South Africa. Suppliers will normally add a flat fee for 30/60/90-day finance and this should also be annualised to compare rates properly.
As mentioned, the cost of trade finance is directly related to the strength of the company’s balance sheet and its ability to repay the finance.
Be aware of some finance providers adding layers of fees to the transaction, making it difficult to assess the competitiveness and transparency of the fees and the total effective cost of the finance.
Other Trade Finance Terminology As mentioned, the term “trade finance” is often confusing and can be made up of one or a combination of the following finance methods:
Invoice discounting: Clients can raise finance against a good debtor’s book.
Factoring: Similar to invoice discounting or debtors finance.
Receivable finance: As above.
Export credit backed finance: Exporters can provide finance to importers against guarantees/subsidies provided by the Government of country of origin.
Back-to-back finance: Banks use the strength of the buyer’s financial status to make the transaction “bankable”.
Stock financing: Finance to enable clients to purchase stock.
Collateralised finance: Finance is secured by combining various assets/purchase orders as security.
Discounting of letters of credit: Exporters may discount the future proceed to be received under a letter of credit.
Re-financing of letters of credit: Importers may obtain extended finance by request banks to re-finance a letter of credit.
Discounting of Avalised Bills of Exchange: Exporters may discount the future proceeds under a bill of exchange or promissory note where the instrument is guaranteed by a bank.
Supply chain finance: Trade finance that uses as set of technology-based solutions that aim to lower financing costs for buyers and sellers. Normally suited for large multi-national companies.
Structured/Specialised trade finance: As per explanation below
The above is not an exhaustive list and there are many other terms also being used depending in which global market that being operating in. The bottom line is that ALL finance arrangements will be determined by financiers after considering the normal lending principles.
Another expression that is often used, is whether a finance request is “bankable”. This simply means if the parties to the transaction are found to be of good faith and that the underlying transaction and goods meet all the “know-your-customer” (KYC) and Anti-money laundering (AML) criteria. A transaction is also “bankable” if the lending party shows financial substance and demonstrates clear evidence of the ability to repay the capital and interest as outline in the loan agreement.
With/Without Recourse Finance
Do all finance arrangements happen with recourse to the lending client? Whilst most trade finance arrangements are made with recourse to the party seeking the finance, as referred to above, trade finance could also be done on a without recourse basis to the lending customer.
In some instances, banks will provide finance to an exporter by discounting the proceeds under a term letter of credit received by the importer’s bankers. In such instances the exporter’s bank will be happy with the credit and sovereign risk of the importers bank and will pay the exporter in advance whilst waiting for the ultimate payment to be received by the importer’s bank on maturity. This is referred to as “without recourse” finance as the exporter will received funds in advance after having extended payment terms to the importer. Naturally, the exporter will include the cost of discounting the letter of credit, in the price to the importer.
Similarly, an Importer that is required to pay at “sight” of the goods imported, may request his bank to re-finance the letter of credit by paying the exporter on his behalf and in turn provide extended terms to him. Banks can also use bills of exchange to provide finance to importers and exporters on a similar bases, especially if the counterparty bank has Avalised (guaranteed) the bill of exchange due for payment at a date in the future.
Structured/Specialised Trade Finance Due to the high risk normally associated with Structured/Specialised trade, not many banks are offering this solution. The crux of this type of trade finance is that a lot more reliance is placed on the underlying goods, the logistical process, insurance, and the ability of the underlying parties to perform and to make payment. All delivery and financial risks are carefully scrutinised and mitigated across all the elements of both the physical and financial supply chains. Whilst some reliance will be placed on the lender’s financial position, the “bankability” of the transaction is accessed through all the other factors and the financier’s ability to control all the aspects of the movement of goods from a risk perspective.
A high level of structured trade knowledge including trade finance and the full supply chain is necessary to enable this type of finance, whilst also making use of all the standard trade disciplines, foreign exchange risk management, payments, letters of credit/bills of exchange/escrow accounts, logistics/insurance available from within the bank as well as external solutions, to structure ‘bankable” transactions. The fees and interest rates associated with these types of transactions are naturally higher than traditional trade finance, due to the increasingly higher levels of exposure and risks undertaken by the bank.
In closing, the benefits of availing of Trade Finance can be summarised as follows:
Provide much need funds as rapid growth has consumed all available cash
Facilitate additional inventory or raw material purchases where price increases have materially exceeded inflationary rises
Enable the expansion of existing product range
Freeing up general banking facilities blocked by Letters of Credit
Seasonal or cyclical cash flow fluctuations which are not catered for by general banking facilities
Opportunistic purchases of parcels of inventory from time to time
Taking advantage of early settlement discount offered by suppliers
Improved pricing for bulk orders
Dispensing with the need to offer settlement discounts which erode gross margins
Avoiding the need to change commercial banking relationships to obtain higher facilities
Additional layer of funding over and above normal banking lines which provides added flexibility
BeztForex has the skills and experience to facilitate nearly any type of trade finance transaction though any one of our various partners and we are able to provide importers/exporters with much needed advice regarding the most cost effective solutions for your company. Get in touch today for the best in breed advice.