Trade Finance Products: What They Are & Their Benefits (2024)

The 3 Most Common Types of Trade Finance Products

Over 80 percent of global trade relies on trade finance or credit insurance for a reason.

Why? Because it helps businesses handle their risks properly, ensure the smooth flow of transactions, and avoid any cash flow imbalances.

This article will explain all you need to know about trade finance products, including what they are, how each type works, their features, and how they can benefit your business.

Here's how they can help your business.

• Improved Cash Flow: Free up money that is tied up in your inventory and unpaid invoices (receivables). Trade finance helps bridge the gap between when you ship your goods and when you get paid, so you don't have to rely on extra loans.
• Enhanced Cash Flow Management: Gain better visibility and control over your finances for strategic decision-making.
• Competitive Advantage: Offer more attractive payment terms to both suppliers and customers, increasing your overall competitiveness.
• Risk Mitigation: Mitigate various risks associated with international trade. These include payment risks, currency fluctuations (exchange rate risks), and even political or economic instability in certain countries (country risk).
• Improved Efficiency: Streamline your international transactions with faster settlements and automated processes. Trade finance tools can simplify complex procedures and expedite the flow of goods and payments.

A letter of credit is a bank-issued guarantee for the seller (exporter) to receive payment if they meet the agreed-upon terms of the sale.

Essentially, it represents a commitment from the bank to pay the exporter within a specified timeframe, based on negotiated conditions.

Important: Banks typically require a deposit or collateral to issue LCs, ensuring they're protected if something goes wrong.

While there are various types of Letters of Credit (LCs), here are the most common ones among international traders:

• Irrevocable Letter of Credit (Import/Export Credit): The most common type. It guarantees payment to the seller (exporter) upon meeting agreed-upon terms as long as the issuing bank fulfills its obligations.
• Confirmed Letter of Credit: This is a special type of irrevocable LCs where an additional bank (confirming bank) guarantees payment to the seller, even if the issuing bank fails to meet its obligations. It offers the highest level of security for sellers but comes with additional costs.
• Standby Letter of Credit: This acts as a backup guarantee. If the buyer fails to meet their obligations, the bank steps in and pays the seller.
• Transferable Letter of Credit: It allows the seller (beneficiary) to transfer either part or all the payment to another supplier involved in the transaction.
• Revolving Letters of Credit: This allows businesses to make multiple transactions under a single LC until they expire, which suits ongoing partnerships.

Usually, when the importer (buyer) wants to purchase products from an exporter (seller), the buyer will reach out to their bank along with a purchase order to request the Letter of Credit.

Depending on their credibility, the bank will issue the LC. Then importer’s bank will send the LC to the exporter’s bank.

As soon as the exporters receive the letter and verify the terms, they will clear the bank, and the goods will be ready to be shipped.

After that, the seller’s bank will issue the payment to the seller. Then, the buyer’s bank will receive the forwarded shipping papers, and the importer will request the payment.

Note: The process can be time-consuming and requires careful compliance with detailed documents. Also, once issued, changes are difficult and expensive.

There are many benefits when using a Letter of Credit as your trade finance product, such as:

• Reduced Risks for Sellers: Offer more security while building better reliability on payment for the seller.
• Streamlined Transactions: Provide a precise timeline for the completion of transactions for all parties involved.
• Flexibility: Terms of use can be personalized to each specific transaction, depending on the situation of the parties involved.

Purchase Order (PO) finance is designed for SMEs who face inefficacy or cash flow problems.

This is part of the pre-shipment solutions for trade finance.

Essentially, it provides capital to pay suppliers with the verified purchase order to guarantee smooth cash flow. It enables businesses to accept a large volume of orders and adjust the loan amount to meet their needs.

It’s especially true for SMEs as most of the time they receive a large volume of orders but don’t have enough working capital to process them. It solves exactly that problem.

PO finance advances to a certain percentage by the financial institution, usually 30-70% of the purchase order amount.

Even if the volume of orders decreases, there are no tied arrangements, which means you can stop using it anytime you want.

If your business is considering PO finance for more flexible cash flow, here are a few of the simple requirements you should pay attention to:

• Sell to B2B & B2C customers
• An order of > USD 20,000
• Sell finished products (raw materials or product parts are not accepted)
• Have a healthy profit margin (around 15 - 20%) to cover the cost of financing
• Creditworthy customers
• Reputable suppliers (manufacture & deliver products to customers on time)

Tip: Lenders focus on three major factors for PO Finance qualification: the size of the order, the creditworthiness of the customer, and the profit made on high-volume orders.

Once you have a verified purchase order, you can apply for PO financing. Then, the financing provider will assess your business and the legitimacy of the order.

If approved, the financing provider will pay your supplier directly, covering a significant portion of the order value. With the supplier paid, you can now focus on fulfilling the order without worrying about cash flow.

Once your customer pays you, you can use those funds to repay the financing provider, along with any applicable fees and interest.

Using PO finance as part of your pre-shipment solutions can offer plenty of benefits, which are:

Increased Sales and Inventory: The ability to grow sales and maintain more inventory even when you're limited by capital.

• Optimize Cash Flow: Offering funds to bridge the period between paying suppliers and receiving payment from customers, which can often span 60-90 days post-shipment.
• Easier Access to Capital: Compared to traditional bank loans, it can be easier to obtain, especially for younger businesses or those with limited credit history.

The main goal of Supply Chain Finance is to improve the payment terms and make your cash flow more flexible in the supply chain process.

The buyer would negotiate payment terms, including an extended payment schedule.

At the same time, the seller can also get immediate payment while quickly unloading the products.

In essence, it's a win-win for everyone in the supply chain – you (the seller), your buyers, and even the financial institution involved.

Now, we should clarify this one thing first: supply chain finance is not a loan per se.

In fact, it is a technology-based cash flow solution that lowers financial costs for both parties.

The good thing about it is that it frees up some of your working capital while you wait for the shipment to arrive.

So your money won’t get trapped in the supply chain and make your cash flow more flexible.

After the supplier delivers goods or services and sends an invoice to the buyer, the buyer verifies the invoice and approves it for financing.

Upon verifying the invoice, the buyer approves it for financing. A financial institution then steps in, paying the supplier a significant portion of the invoice amount on behalf of the buyer minus a small fee or discount.

On the original due date, the buyer pays the financial institution the full invoice amount.

Note: Typically, lenders calculate fees based on the buyer’s credit, as they are ultimately responsible for repaying the full invoice amount.

There are two major individuals involved when it comes to SCF - a supplier and a buyer.

For Suppliers:

• Faster Payments: Instead of having to wait for the 30-day credit terms, the supplier can be paid earlier;
• Improved Liquidity: Access cash flow sooner to reinvest in the business.
• Reduced Risk (Optional): In some cases, SCF programs may offer optional credit insurance.

For Buyers:

• Extended Payment Terms: Manage cash flow more effectively by negotiating longer payment terms with suppliers.
• Healthy Balance Sheet: Maintain a better financial appearance with extended payment terms without a negative impact on supplier networks.
• Simplified Supply Chain Management: Streamline processes and work effectively with complex supplier relationships.

The good thing about trade finance and its products is that it can unlock capital from your business’s existing stock or receivables based on the trade cycles in your company - the key point is to reduce your payment gaps.

By reducing these gaps, you can significantly minimize exchange rate risks and maximize the efficiency of your trading cycle.