Quick guide to understanding trade financing (2024)

Businesses of all sizes use trade financing to provide supply chain security and risk mitigation. With trade financing solutions, businesses ensure they have the capital to cover the cost of goods and services when dealing with international suppliers.

This network of supplier and buyer support is especially important in light of current supply chain disruptions and the rapidly changing global economy. International trading gives companies increased access to goods and services to improve operations while protecting their bottom line.

Today we’ll share the basics about trade financing and how it helps businesses broaden their reach and take advantage of the best possible supply prices and outcomes.

• What is trade financing?
• Why is trade financing important to buyers and sellers?
• What are the benefits of trade financing?
• What are the steps in a trade financing transaction?
• What are the different types of trade financing?

Download the free ebook: How Automation Can Solve Finance Teams’ Biggest Challenges

What is trade finance?

Trade financing is the practice of providing funding or credit assurances to businesses engaged in international trade. Trade financing helps these businesses bridge the financial gap to cover expenses like goods, shipping, and other related services for a successful international transaction. It also provides credit and risk management and fraud prevention for parties involved in international trade transactions.

International purchasing can be complex. Trade finance aims to reduce the complexity of international trade and mitigate risks associated with international trading.

Some of the services involved in trade finance include:

• Mitigating credit, foreign exchange rate, and non-payment risks
• Arranging for letters of credit
• Invoice factoring and discounting
• Obtaining insurance coverage for transactions

Trade finance provides the tools and financial instruments that help businesses manage the risks associated with global trading to take advantage of the benefits of operating on the international market.

Why is trade finance so important?

According to research from Oxford University, international trade drives most modern economies, with over 80 percent of trades utilizing some form of trade financing. Buying or selling goods through unknown or untested international partners presents risks for both parties. Trade finance helps to reduce risks by providing communication and documentation to solidify vendor relationships.

Trade finance also enables businesses to access a larger market and tap into expansion opportunities. It helps them secure favorable payment terms and take on more complex projects.

These services make navigating exchange, currency, and tariff issues inherent in international trading easier, which helps parties minimize losses or penalties.

How trade finance works

Successful trade finance relies on a network of professionals that help domestic companies navigate the complexities of international transactions. There are many players in the trade finance space.

• Banks and lending institutions
• Trade finance agents
• Suppliers and exporters
• Import and export specialists
• Insurance companies
• Export credit agencies
• Shipping and logistics agencies

The process of trade financing

Although the details of a trade financing deal are specific to the parties in the transaction, in general, a simple trade finance transaction proceeds as follows:

1. Negotiate terms - The seller and buyer set the parameters of the deal by agreeing to terms such as documentation requirements, payment method, delivery date, and financial incentives.
2. Apply for financing - The exporter applies for a loan from a bank or other financial institution to fund the transaction.
3. Secure payment - The exporter receives either an irrevocable letter of credit (LC) from the importer’s bank or an advance payment guarantee (APG) from their own bank, which guarantees payment if all conditions are met.
4. Fulfill the contract - After securing funding, the exporter fulfills their obligations under the contract and ships the goods as agreed upon.
5. Collect payment - Once all conditions are met, exporters collect payment via wire transfer or other remittance forms according to the agreement.

5 Benefits of trade finance

Trade financing is a valuable tool that provides assurance and peace of mind to all parties and protects them against potential monetary losses or disruptions within the supply chain. Buyers are assured of payment upon contract fulfillment, while sellers are provided capital to cover their production costs. Beyond the logistical support, trade financing provides many other benefits.

1. Better security

Trade finance provides an extra layer of protection to ensure both parties perform their roles. Exporters can use trade financing to secure funds from their banks to guarantee payment if all conditions are met. This ensures that, even if the importer does not pay for the goods, the exporter still gets paid, provided all conditions are met.

2. Reduced documentation

Unlike other financing options, the documentation for trade financing is minimal. Trade financing is usually secured against various collateral, such as assets, invoices, or securities. The bank can provide the funds without much additional paperwork if these documents are in place.

3. Cost savings

Trade financing can also save businesses money by helping them avoid high-interest loans or transaction fees. Businesses can avoid large capital outlays for higher-risk transactions by taking out a loan.

4. Faster transactions

Trade financing speeds up transactions significantly by providing upfront funds. Trade financing allows buyers to purchase goods without waiting for payment from the customer and allows exporters to ship on credit with confidence. This reduces the time it takes to complete a transaction and can help businesses stay competitive.

5. Access to more opportunities

Trade financing helps businesses access new markets and customers. It lets them offer attractive terms and payment plans to increase their sales. The upfront funding from trade finance also enables businesses to tackle larger projects or scale quickly to meet customer demand, thus opening up a wealth of possibilities for expanding their operations.

Types of trade financing

Different types of financial products and services exist to meet the needs of different businesses and their specific circ*mstances. For example, a business may require long-term financing to cover large capital investments, while another may need short-term financing to cover one-off purchases. The following are the most common forms of trade financing:

Purchase order financing uses an intermediary, such as a bank or other financial institution, to provide funds to a business so it can pay its suppliers upfront. This reduces the risk associated with trade on credit. Purchase order financing can also be used for larger transactions and investments, which allows businesses to benefit from economies of scale when buying goods or services in bulk.

Supply chain financing enables companies to pay their suppliers sooner while giving buyers more time to pay without affecting their working capital. It allows small businesses (SMBs) to use their accounts receivable as collateral for a line of trade credit. This lets suppliers receive payment quickly, enabling buyers to improve their cash flow.

Ecommerce financing supports online businesses, for instance, print on demand (POD) or dropshipping stores. This form of financing helps businesses finance inventory and other related expenses to run their ecommerce operations, such as ordering goods from suppliers and processing payments from customers. Ecommerce financing also helps provide liquidity to cover the gap between purchasing goods from suppliers and collecting revenue from customers.

Trade loans and lines of credit provide cash flow assistance for ongoing trading activities and often have lower interest rates than typical bank loans due to the security offered by tradable assets such as inventory, raw materials, etc.

Documentary credits are credit arrangements between banks and businesses that involve payment against the presentation of documents such as a bill of lading. This is also called a Letter of Credit or documentary collection.

Factoring is a process where a business sells its unpaid invoices at a discounted rate in exchange for an upfront payment. The factor then collects the invoice from the customer.

Discounting is a process in which businesses sell their invoices at a discount for immediate cash flow. It is similar to factoring but does not involve any collection services from the lender.

Purchasing platforms help businesses acquire goods quickly and efficiently from global trade partners while helping them manage their global trade finance. Through a procurement platform, businesses access a global supplier marketplace to find the best price and delivery terms for needed products. The platform provides an integrated solution for trade finance so businesses establish payment terms with international suppliers without taking on extra risk or incurring expensive fees.

These options protect businesses against any losses or delays in supplier payment. By providing a comprehensive solution to international purchasing and trade finance, a procurement platform can help businesses reduce costs and take advantage of new opportunities in emerging markets.

How Order.co enables trade financing

Order.co offers streamlined solutions to their purchasing challenges. Through the platform, businesses have access to a well-vetted network of their preferred suppliers — providing them with the confidence to expand their reach and explore new procurement opportunities.

In addition, Order.co provides spend efficiency and management features to help buyers understand their total cash position and optimize spending:

• Financing and extended terms through Order.co Financial Offerings to create flexibility for buyers
• Automation and reporting features to understand your current liabilities and cash position
• Budgetary control features to ensure buyers spend within prescribed limits based on role, department, location, and more

To see how Order.co secures and optimizes every purchase, schedule a demo.