How does Trade Finance work?

How does Trade Finance work?

If you’re wondering ‘How does Trade Finance work’, then you’ll be coming to that point in your business when you are thinking about increasing sales and growing. And that new direction will almost definitely require you to purchase goods and services to increase sales and profitability.

International business is a mega opportunity; for example, you might be able to source a better quality product at a better price by using a supplier in another country. On that note, trade finance often lends itself to international trade but it can also be used with suppliers domestically and globally.

Wherever, it may be, if a supplier requires payment for goods they have manufactured and is not extending credit to the buyer then trade finance can provide help in conjunction with invoice finance or invoice factoring.

Trade Internationally

Here’s a good time for a word about Brexit and the UK’s moving away from the single European market and making Great Britain great in new markets whether existing or emerging markets.

Whatever happens with politicians, always remember that people, companies and countries will do business with each other. It never stops and it never will. What changes is the political arena in which you have to operate. So, business goes on, it’s just the rules that change.

That’s not underplaying the importance of Brexit, but business people know that they have to work within the regulatory framework in which they operate and need to respect local laws and cultures. If there is a hard Brexit, margins will take a battering because the costs of doing trade, mainly in the form of trade tariffs, the UK could stay in the single market or operate under WTO rules and regulations which can be imposed. Even a soft Brexit, in which we reach an understanding with our European neighbours, still means that some tariffs and custom control costs will have to be factored into the equation.

How does trade finance work?

It’s a type of commercial finance whereby a lender essentially pays the supplier or manufacturer of the goods on the buyer’s behalf. For the seller, it gives them comfort that they will be paid upon releasing the goods. For the buyer, it protects their cash flow as they do not have to pay out the money themselves.

How does it actually work? It is main role is to remove the risk between those companies wishing to trade with each other. The seller might be worried that they aren’t going to get paid by the buyer, particularly if it’s a company they’ve never heard of based in another country. The buyer might not have the cash available to pay for the order upfront, especially if they’ve made multiple orders.

Third party

What trade finance does is bring a lender into the equation. They come in to solve a problem for both parties. The seller gets paid, as per the terms of the contract, whereas the buyer gets extended credit. And these arrangements are usually transactional, just to cover the individual deals.

Break trade finance down further and you hear such terms as import finance, purchase order finance and supplier finance. But, whatever term is used, the whole idea is to remove the risk from the transactions, especially at the start of relationships, when you usually have no idea about the person you are dealing with.

Letter of credit

So one way to work around this problem is for a third party, usually the importer’s bank, to draw up a letter of credit. This document, from an institution that can be trusted, the bank, acts as a guarantee and says that once it receives proof that the goods are on their way to the importer (the buyer), then it will release the money to the exporter (the seller). In this way, everyone is a winner, because the third party, the bank, the one that can be trusted, acts as a middleman.

Lenders charge for this service of course and the process can be time-consuming and costly, but it is a great example of how trade finance works internationally.


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Categories: Trade Finance Services