The Trading Finance Guide for Export Businesses
The world has now become a truly global marketplace, which means there is intense competition for businesses. If you want your export business to grow, you have to offer flexible payment and finance terms to your customers. However, you also need to ensure that you get paid on time and in full. Consequently, the decision of selecting an appropriate method of finance for an individual export sale can be of the utmost importance. The transaction needs to be attractive for the importer, but also either negate or minimize the risk of non-payment for exporters.
When it comes to trading finance, you need to take a look at the different methods of payment available for international trade. In addition, you also need to consider the finance options that exporters can use for growing their overseas business.
If you want your export business to grow, you have to offer flexible payment and finance terms to your customers.
Methods of Payment in International Trade
When it comes to international trade, there are four major payments methods that can be used, which cash in advance, letters of credit, documentary collections and open account. Let’s take a look at each method, along with their risks and benefits.
- Cash in AdvanceUnder this payment method, the exporter will receive upfront payment from the buyer before the goods are shipped, normally by credit card or wire transfer. This payment method is clearly attractive for exporter because there is absolutely no risk of non-payment. In contrast, the buyer has to deal with 2 major issues. The first is cash flow because they are required to lay out all the cash for the transaction before they can receive, much less sell the goods. Secondly, they have to deal with concerns or risks about the exporter actually shipping the goods once payment is received.It should be noted that exporters offering only this payment method are at a serious disadvantage. If the customer can get credit terms for the same goods from anywhere else, then you are more likely to lose the sale. This means that you won’t be able to make sales to a lot of credit worthy and high value businesses. Cash in advance is best used when the importer is an unestablished business or a new customer, their creditworthiness is unsatisfactory or unverifiable, the commercial or political risks of the importer’s country are high or when your product is unique and in high demand.
- Letters of CreditAnother common method of payment for international transactions is letters of credit (LCs). Put simply, an arrangement is setup between the buyer and their bank for releasing funds that are guaranteed by the bank upon fulfillment of terms of trade. A set of requirement documents listing the terms would be needed for release of funds. This payment option is particularly handy when the buyer is an unsatisfactory credit risk for exporters, but they can accept the creditworthiness of their bank.The buyer also remains protected because no payment has to be made until all trade terms have been fulfilled. Since letters of credit can be complicated arrangements with chances of discrepancy, they should either be outsourced or prepared by expert documenters. It should be noted that no matter how small a discrepancy, it could become an excuse for non-payment. There are several types of letters of credit that can be used, which include irrevocable letter of credit and confirmed letter of credit. There are also special letters of credit, which are resolving, standby and transferable.
- Documentary CollectionsWhen this payment method is chosen for international transactions, the exporter’s bank will now take responsibility for collection of payment. Documents are sent by the exporter’s bank to the importer’s bank with instructions of payment. The exporter doesn’t really get any real guarantees for this method of payment and there is limited recourse available in case they don’t receive the payment. However, this option is a lot cheaper to set up as compared to an export deal or setting up a letter of credit.There are 2 types of documentary collection transactions. The first is called the documents against payment (D/P) collection. In this scenario, the goods are shipped by the exporter and then they forward the documents to their bank. The bank then forwards them to the importer’s collecting bank, including instructions for payment, and the documents are then released when full payment is received. The second is documents against acceptance (D/A) collection in which the method of payment is to extend some credit to the importer. The credit is a type of ‘time draft’, which legally obliges the importer to pay for the goods at a specific date.When the date arrives, the importer is contacted by the collecting bank for payment. The funds are then forwarded to the remitting bank for crediting to the exporter’s account.
- Open Account TransactionsThese transactions are ones that involve the exporting extending credit to the importer. The payment terms are typically between 30 and 90 days once the goods have been delivered. This is clearly great for the buyer because they can get the goods and get a chance to sell them for covering their cost of purchase. Hence, they don’t need to dip into their extinguishing cash flow or reserves for importing goods. However, this is the riskiest option for the exporter. They need to ship the goods, wait for an extended time period and then rely on the customer to make the payment on the agreed date.Luckily, there are different finance options that an exporter can find for offering open account terms to their overseas clients. It is possible to combine them with insurance and other products for negating the risk of non-payment.
Export Finance Options for Exporters
It is a given that if you want to win customers in competitive markets, businesses need to offer flexible and attractive payment terms to their clients. As already mentioned, open account or credit terms are the most beneficial for importers. There are several solutions available that can help your export business grow, all of which enable you to extend credit to your clients and some can also help in financing your stock or equipment. Let’s take a look at the options:
- Export Working Capital Financing
Offered by a commercial bank, the purpose of export working capital financing is to support export sales. Funds can be given for purchasing the goods and services that need to be exported and for easing cash flow. This allows exporters to provide credit terms to their clients. It is possible to set up an export working capital financing facility for a specific deal or as a general facility for financing multiple export sales. As far as individual transactions are concerned, the facility is usually provided for a year whereas general facilities are usually given for three years.
In order to quality for export working capital financing from a commercial bank, an exporter has to demonstrate their profitability, a need for this facility and that there is a viable transaction or deal that can be made. Depending on the risk, some form of security may be demanded by the bank. This could be a personal guarantee or a charge over the business’s assets. It is also standard for banks to collect receivables from the customer directly, deduct any fees and then pass on the remaining balance to the exporter.
Transaction specific export working capital financing are usually short-term and are taken out for covering an atypical or large export order. The term of the loan falls between 3 and 12 months and generally, the interest rates are fixed. Businesses that want to enjoy a level of financial comfort would prefer to get a revolving line of credit because it allows them to complete regular export deals. This is the ideal option for export companies that don’t have a predictable order book and have to put up with troughs and peaks in their business.
- Government Guaranteed Export Working Capital Programs
In situations where commercial banks are unwilling to lend or their borrowing limits are insufficient for meeting the requirements, some governments also offer a guaranteed scheme for helping exporters in getting access to the finance they need.
Mitigation of Non-Payment Risk for Export Businesses
To protect exports from the risk of non-payment when they are offering open account terms, a risk mitigation option has to be included in export finance. Outlined below are the 3 most effective solutions for mitigating risks:
- Export Credit Insurance
This form of insurance is designed to protect an exporter against the risk of non-payment in international transactions. As long as they have a good export credit insurance policy, they will be protected from buyer defaulting or bankruptcy, buyer insolvency, currency fluctuations and political risks, such as terrorism, war, revolution, riots etc. It is possible to option export credit insurance for one transaction or you can apply for a general policy that covers various export deals. Both short-term transactions that last for a year and medium-term transactions that fall between one and five years can be covered by the policy.
The best thing about this particular option is that it protects the exporter against the risk of non-payment and allows them to offer competitive open account terms to overseas clients. Export businesses are able to expand their operations in emerging markets, which could be classed as a higher risk. Also, when you have insurance for foreign receivables, banks are more comfortable in lending money.
With a short-term policy, 90 to 95 percent of the transaction value is insured against non-payment. Coverage of up to 180 days is available for consumer goods and services whereas 360 days are provided for small capital goods, bulk commodities and consumer durables. As far as medium term export credit insurance is concerned, it will give you around 85% coverage on large capital equipment and transactions of up to 5 years are covered. As far as the cost of export credit insurance policy is concerned, it will depend on the size of the transaction, the importer’s creditworthiness and the commercial experience of the exporter.
Multi-transaction policies generally have a cost of 1% of total sales value, but the rate varies for individual transaction policies as per the factors outlined above.
- Export Factoring
If you are looking for an all-in-one and complete solution for exporters, export factoring is the best option as it combines credit protection, working capital financing, collection of accounts receivable and foreign accounts receivable bookkeeping. The exporter’s short-term foreign receivables are bought by a factor at a discount from the book value. All collection responsibilities and the risk of non-payment is transferred to the factor. This provides an exporter with 100% protection from payment default. But, since the value is discounted, this option could be more expensive than export credit insurance.
Factoring offers more advantages to businesses that are facing a rapid growth in their export sales as they are able to get cash for sales upfront at a discount, which allows investment in additional stock. There are two primary types of factoring arrangement. First is discount factoring in which the factor pays an advance of funds to the exporter against their foreign receivables until they collect them from the importer. The second option is referred to as collection factoring in which the value of the sale is paid to the exporter, minus a commission charge, when the receivables are due. The cost of the commission is between the range of 1 and 4 percent, depending on the factor’s risk.
This is quite similar to export factoring as your foreign receivables are sold to a third party. But, unlike factoring, it is possible to use forfaiting for financing medium to long-term transactions, which include payment terms up to 7 years. The importers’ bank will usually guarantee the receivables and this allows the exporters to remove the transaction from their balance sheet and have the comfort of receiving payment. There is a minimum transaction amount that’s typically set for forfaiting. This method completely eliminates the risk of non-payment and gives you 100% financing of contract value.
With forfaiting, an exporter is able to offer open account terms for large export deals in risky markets. They can get a guarantee from the importer’s bank and the interest rate for the term is generally fixed.
Finding the Right Trade Financing Solution for your Business
No two businesses are the same and there are a number of factors to consider when you want to select a trade finance solution, or a mix of solutions, for your business. It is important for you to consider the needs of your business, the kind of clientele you have and then pick an option that works for you.
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