Trade Financing (2023)

What is Trade Financing?

Trade financing is the financing of domestic and international trade and commerce.

Trade finance consists of many different financing instruments like invoice factoring, import financing, export financing and insurance, lending and the issuance of letters of credit. It can provide for working capital financing on underlying trade transactions via supplier invoices or trade receivables.

Typically, the parties that are involved with trade finance include importers and exporters, banks and institutional financiers, trade credit insurance companies, and service providers.

How Does a Trade Financing Work?

The role of trade finance facility in commerce and international trade is essentially to mitigate payment risk and supply risk by providing the exporter with receivables and the importer with a line of credit.

Still looking / sounding like Greek to you…?

Simply put:

It protects the interest of both buyers and sellers internationally.

Trade facilities are instruments which are most commonly provided by banks, financial institutions, trade finance houses, and sometimes in-house by either the buyer or supplier.

Unlike business loans, repayment terms in trade finance are generally between 30 – 120 days. This financing acts as a safety net to protect the interests of buyers and sellers in an international marketplace.

With the assurance of having sufficient funding to start on new projects, and sufficient cash flows to sustain the business while awaiting payments from clients, trade finance now gives you the confidence to embark on bigger projects and focus on growing your business.

Reading on, we will focus a little deeper on three aspects of trade financing. These are the main trade financing products:

  1. Purchase Order Financing
  2. Invoice Financing
  3. Business Overdraft Facility

1. Purchase Order Financing

Purchase Order Financing is a short-term commercial trade financing facility that provides immediate funds to pay suppliers upfront for verified purchase orders.

Generally, two essential situations that businesses try to avoid are, draining cash reserves, and/or declining an order because of cash flow problems in making payments to suppliers.

Purchase order financing allows companies to take on large orders, and provides for flexibility in increasing or decreasing loan amounts quickly to meet needs. If general business volume drops, there are no long-term commitments, and companies are able to pause in utilizing the facility with no additional charges.

How Does Purchase Order Financing Work?

Your company receives a large order from a customer. Your supplier needs an upfront payment, but your customer invoice will not be paid for 30-90 days after shipment is received. This creates a gap in your cash flow. Without enough money, you risk losing the order and customer confidence.

With a verified purchase order, a purchase order financing facility will allow a bank or financial institution to pay the suppliers upfront, directly via a letter of credit or cash. Your business then fulfills the order, and you pay the bank/financial institution back after 120 days.

Who Uses It?

Purchase order financing is typically for growing businesses that want to take on the unusual larger orders. While purchase order financing is a commonly used source of financing for a myriad of business types, the more common types of businesses that usually qualify include:

  • Manufacturers
  • Distributors
  • Wholesalers
  • Importers/exporters

2. Invoice Financing

Invoice financing is a form of asset based financing within trade finance that allows you to get access to financing based on account receivables. There are 2 ways to finance your invoices:

  1. Spot factoring: where invoices can be sold to an invoice factoring company in exchange for immediate funds that can be used to improve working capital and pay for general company expenses.
  2. Using account receivables to secure a revolving line of credit, where the credit limit is based on a myriad of factors, such as the financial strength of the company and/or the financial strength of the proposed debtors.

Factoring can be easier to obtain than business loans because companies are selling an asset rather than getting an unsecured loan. A key requirement to qualify is to have invoices to credit-worthy commercial clients, such as government agencies or big multi-national companies that are financially strong and reputable.

As a result, factoring is as an alternative option to small businesses that do not have substantial assets or a proper credit history.

3. Business Overdraft Facility

An overdraft facility is a short-term (usually up to 12 months) standby credit facility which allows you to issue a cheque or withdraw cash from their current account up to the overdraft limit approved. It is usually renewable on a yearly basis, and repayable on demand by the bank at any time.

An overdraft limit is the maximum amount that a company can overdraw from the current account. Interest is only payable on the amount overdrawn, calculated on the daily balance overdrawn, and debited from the account monthly.

Any unpaid amounts of interest are added to the overdrawn amount in the following month. Interest rates on an overdraft account is usually charged at a percentage over the bank’s prime lending rate, for example, Prime + 3% per annum.

The facility acts as a revolving credit facility where, whatever amount repaid into the overdraft account can be withdrawn again as long as the total outstanding amount is within the overdraft limit granted.

Types of Overdraft Facilities

There are 2 types of overdraft facilities: 

An overdraft facility could be either secured or unsecured.

secured overdraft requires for a company to pledge an asset to the bank as security. The asset pledged could be deposits in the bank, property or shares. In an event where the bank stops the secured overdraft facility and the company is unable to repay the outstanding debt, the bank reserves the right to recover the outstanding amount by selling the pledged security.

An unsecured overdraft facility does NOT require for any kind of pledged asset as security. In Singapore, banks are generally able grant unsecured overdraft limits of up to 25% of a company’s yearly revenue, subjected to credit scrutiny of the company’s financial health and credit exposure. There are no minimum monthly repayments for an overdraft facility as long as the amount utilized is within the approved limit.