How Trade Finance works: A basic guide for import/export businesses

In our interconnected world where instantaneous global communication is taken for granted, it’s easier than ever to do business anywhere in the world.

However, while the opportunities are plentiful, the process of buying and selling internationally is not without its risks and complications. There are many variables at play, with volatile exchange rates, cash flow problems and economic uncertainties all posing their own unique challenges.

An increasingly important mechanism for handling these risks and smoothing the flow of business transactions between nations is a set of financial tools collectively known as trade finance.

The World Trade Organization estimates that up to 90 percent of current global trade relies on some form of trade finance. Yet, in its 2017 International Business Survey, the Australian government’s export credit agency (EFIC) estimates that as little as 35% of Australian internationally active businesses have leveraged these tools.

The reasons Australian small and medium sized enterprises (SMEs) aren’t capitalising on financing opportunities are varied. However, one reason is simply a lack of information on how the process works.

Let’s breakdown the process so being uninformed is no longer a barrier to entry for international trade.

Basic Mechanisms for International Trade

There are a few basic financial mechanisms which form the foundation of international trade transactions. These simple tools have many limitations when used in isolation, but they are vital building blocks for more sophisticated trade finance solutions.

Telegraphic Transfer and Open Accounts

Telegraphic transfer is a simple, fast and straightforward way of moving funds between buyers and sellers. It’s essentially an electronic way of paying cleared funds to a designated bank account.

While it remains one of the most common and practical methods of payment in trade finance transactions, used in isolation it has one significant shortcoming – it imposes significant risk on the buyer.

Without any means of quality assurance or of even obtaining a guarantee of delivery, the buyer is exposed to the possibility of not getting the service or merchandise they paid for. Put simply, a telegraphic transaction pushes all risk onto the buyer.

An alternate mechanism is for the exporter to use an open account. In this arrangement, the exporter extends an open line of credit to international customers, with a request to be paid on delivery.

Obviously, this is a great arrangement for the buyer. The exporter, however, is accepting considerable risk. Not only is the exporter dependent on the good faith of their customer, they’re also vulnerable to unforeseen circumstances in the shipping process, unfavourable exchange rate variation and the list goes on.

Both illustrate an important basic principle for trade finance: the importance of mitigating risk.

Letters of Credit

A letter of credit is a trade financing mechanism designed to allow both buyers and sellers to mitigate some of the inherent risks in international trade, such as non-payment, currency value fluctuation and political or economic instability.

In somewhat simplified terms, here’s how it works.

When a buyer (the importer) wishes to purchase goods from an exporter, they’ll approach their bank with a purchase order. Provided they’re creditworthy, the bank will then issue a letter of credit.

The exporter’s bank will then request the letter of credit from the buyer’s issuing bank. Once the letter is received and its terms verified, the exporter’s bank will clear the exporter to ship the goods.

On receiving the shipping papers, the exporter’s bank will issue payment to the exporter. The shipping papers will then be forwarded to the importer’s bank and payment will be requested from the importer.

By acting as a go-between for the buyer and the seller, a letter of credit greatly reduces both parties’ risk. It’s a critical tool in much of the international trade taking place in the world today.

However, letters of credit only solve part of the problem. They also create their own problems.

While this trade finance instrument reduces risk, it doesn’t eliminate it entirely. Letters of credit are typically filled with complicated and detailed provisions. Any discrepancy or oversight in these terms may nullify one of the party’s payment obligations.

They can also involve slow approval times (months in some instances), which hamstrings importers and exporters alike in responding to market demand.

Perhaps most critically, importers can only use a letter of credit if they’re deemed creditworthy and the line of credit will have a direct impact on the importer’s banking operations.

Enhanced Import and Export Financing Solutions

The letter of credit is a powerful trade finance tool, but on its own it’s insufficient to meet the demands of international business.

More sophisticated and all-encompassing trade finance tools are available. These are designed to allow businesses faster access to finance, greater adaptability to market changes and improved cash flow throughout the entire cycle of order through to shipping and delivery.

Streamlined Credit Arrangements

22% of Australian businesses that do not participate in international trade report that this is due to a lack of certainty on how to begin. Streamlined credit arrangements are designed to provide a simpler and more accessible way for Australian SMEs to do international business.

For example, Scottish Pacific’s Tradeline is designed to offer quick approval times and to be far less restrictive than a standard letter of credit. This product also offers approval times of 5 days and more flexible payment terms than a traditional letter of credit.

Adding to their appeal, these trade finance arrangements typically do not require the buyer to secure credit against existing capital, such as property or cash. This offers a heightened level of financial security and it also means that importers are less constrained by the security they have available.

Import Finance

The goal of import finance is to improve the purchasing power of importers by giving them the option to defer part or all of their purchasing costs until they realise a profit from sales.

Import finance is frequently combined with a letter of credit arrangement to simultaneously offer the importer both greater flexibility and protection against risk factors.

In simple terms, here’s how import finance works.

The buyer will apply for an import finance transaction with a finance institution. Once approved, a letter of credit or telegraphic transfer will be initiated and the seller will produce and ship the ordered goods.

The seller will be paid by the buyer’s bank and an import bill will be created.

Once the goods are cleared and reach the buyer, the import bill will be repaid from debtor finance proceeds. The buyer can then clear the debtor finance on agreed terms.

The benefits here are twofold.

The lengthy period between ordering goods and receiving payment is avoided, assisting both the importer and the exporter in doing business. The buyer will also benefit from quicker growth and stronger sales due to the increased purchasing power import finance can offer.

The cost of this kind of service varies between finance institutions, as do the terms of repayment. As one example, Scottish Pacific’s import finance facility charges interest only when funds are remitted to the exporter and the import finance fee can be adjusted in line with the seller’s unique requirements.

Export Finance

An estimated 93% of internationally active Australian businesses are involved in export.

In scaling up operations for export contracts, Australian SMEs typically experience a sharp increase in manufacturing, capital and shipping expenses, the latter often being considerable given Australia’s relative geographical remoteness from larger international markets.

Long payment terms can further exacerbate their working capital challenges. Delays of up to 180 days for cross-border transactions are commonplace.

Using export finance, sellers can receive funding against invoices raised on overseas customers. There are two major benefits here for the exporter. This removes the barrier of tied-up working capital and alleviates transitional financial pressures.

It also means the exporter can trade on open account terms (usually utilising export credit insurance for added security), thus reducing a critical barrier to international sales.

Export finance is often offered as part of a comprehensive package of services, known as export factoring. With this package of services, rapidly available export finance is provided against invoices. Additionally, collections and international bookkeeping services can be built into an export factoring service, making it an excellent option for SMEs just starting out with exporting.

The Australian Trade and Investment Commission also offers limited Export Market Development Grants (EMDGs) to Australian exporters. The scheme covers part of the expenses incurred on eligible export activities. You can learn more about EMDGs here.

While the world is becoming increasingly interconnected, small and medium sized enterprises in Australia face unique challenges in accessing international markets.

Trade finance is a crucial tool in paving the way for international business. Not only does it open the opportunity for risk mitigation, it offers importers a solution to cash flow challenges and exporters the required capital to fund their expansion.