SME Lending – Trade Finance
A relatively new aspect for Small to Medium Enterprises (SMEs) is access to suppliers and clients anywhere in the world. Fast and efficient world-wide communications and a global economy has opened up sales and marketing opportunities, and cost-saving possibilities for SMEs. Business Finance Professionals play an important role in assisting SMEs to take advantage of and avoid the risks involved in the process of buying and selling internationally.
In taking the leap to expand into overseas markets, there are many complications and variables SMEs and Business Finance Professionals need to be aware of and consider. Political and economic uncertainties, cash flow timings and fluctuating exchange rates all present unique challenges.
Trade Finance is the collective term for the financial tools and mechanisms used to address these challenges, reduce risks and create smooth transactional flows between businesses in different countries.
Despite the existence of trade finance instruments, it has been estimated that only one-third of Australian businesses, active in international business, utilise trade finance when buying or selling. For SMEs, the number would be even lower. By way of comparison, the World Trade Organisation has estimated that around 90% of international trade is reliant on some form of trade finance.
There is a variety of reasons that SMEs aren’t protecting themselves and leveraging opportunities by using trade finance. However, a basic one is that they are unsure of how the process works. This is where a Business Finance Professional can add real value.
Trade Finance Mechanisms
There are a number of mechanisms that can be used in relation to international trade transactions. They range from simple tools to sophisticated and multi-faceted trade finance solutions. The more basic tools have limitations and are usually used in conjunction with other tools to build the right combination of mechanisms to suit the SMEs needs. The aim is to mitigate risk through understanding the specific and unique scenarios the SME is involved with.
The most basic of trade finance instruments is a bank account that allows the transfer of cleared funds to another designated bank account to facilitate an overseas purchase. Also known as a cash advance, it is straightforward and simple, and the most common and practical method of moving funds from buyers and sellers.
However, it has a serious downside if it is the only trade finance mechanism used in SME trades. It places all the risk on the buyer. In essence, the process is initiated by the transfer of funds, and the SME buyer is exposed to the chance of not receiving the products or services they paid for. When, they receive the delivery is also an unknown, as well as the quality of the delivered product or service they have already paid for.
As an alternative to simple banking systems and electronic transfers, an open account is an arrangement where the exporter extends a line of credit to overseas clients with the request to be paid on delivery. This moves the risk from the buyer but puts it squarely on the seller/exporter. The risk is reversed with the seller now relying on the good faith of the buyer to remit funds on receipt of the products or services. The other variables that need to be factored include transport and delivery delays, as well as exchange rate movements.
Letters of Credit
Letters of credit (LC), also known as documentary credits, are legal instruments, issued by banks or specialist trade finance lenders. It is the bank or lender that pays the seller/exporter on behalf of the buyer/importer, as long as the terms of the LC are met.
The buyer/importer uses an issuing bank or lender.
The seller/exporter uses a confirming (or advising) bank or lender.
In general, a LC transaction would happen as follows: -
When a buyer/importer agrees to buy goods from a seller/exporter a purchase order (PO) is issued.
The buyer/importer applies to an issuing bank (or trade finance lender) who will issue an LC pursuant to their lending criteria and analysis (i.e. determining whether the buyer/importer is creditworthy)
The seller/exporter works with their confirming bank who requests the LC be forwarded from the buyer/importer’s issuing bank
The confirming bank then checks the terms of the LC and, if in order, directs the exporter to deliver the products or services.
The seller/exporter then sends the applicable delivery documents to the confirming bank, who will examine the delivery documents against the LC terms, process the payment and on forward the delivery documents to the issuing bank.
The buyer/importer pays the issuing bank
The issuing bank then releases the delivery documents so that the buyer/importer can collect the products or services
The issuing bank then transfers money to the confirming bank who transfer those funds to the seller/exporter
Letters of Credit greatly reduce both parties’ risk as the banks are acting as the go-between for the parties. They have become a fundamental tool in international trade.
However, LC aren’t without their issues and problems. The terms of LC are usually detailed and complex. And any oversight or deviation from the terms of the LC can nullify the obligations and leave the buying/selling arrangement in tatters.
They also come with time constraints as a result of the issuing and confirming banks‘ processes. Approval and turnaround times can be slow, which can impact on the ability to respond to market demands for both buyers/importers and sellers/exporters.
And because it is a financing arrangement, LC have a direct impact on the buyer’s/importer’s debt ratios and credit history.
Streamlined Credit Arrangements
In response to the limitations of LC, especially in relation to the need for faster access to finance, ability to adapt to market changes and to smooth cash flow across the entire cycles of order and delivery, streamlined credit arrangements are now offered by certain lenders.
As well as being simpler and more accessible for SMEs to participate in international trade, streamlined credit arrangements offer quick approval times, and are far less restrictive than standard LC.
For example, these lesser restrictions may not require the buyer/importer to put up existing capital as collateral to secure credit.
Import finance aims to give the buyer/importer greater purchasing power by deferring all or part of their purchasing costs and paying back these costs at a later date, preferably when they have generated revenue from utilising or on-selling the purchased supplies, products or services.
A simple example of how import finance works is as follows: -
The buyer/importer applies for import finance through a bank or lender.
If approved, the bank or lender will provide a letter of credit or process an electronic transfer. This will initiate the delivery of the products or services from the seller/exporter.
The seller/exporter will be paid by the buyer/importer’s bank or lender, and an import bill/credit note will be created.
On receipt of the products or services, the repayment terms of the import bill/credit note will commence, with the buyer/importer clearing the debt as per the agreed credit note terms.
The buyer/importer benefits from avoiding being without working capital between the time of ordering supplies, to the time of receiving payments from sales. It has the added advantage of having access to working capital for other projects.
The costs of import finance and the terms of repayment can vary, quite markedly, from lender to lender.
Exporting is a major activity for many Australian businesses.
Australian SMEs who are involved in export contracts must factor in high levels of capital, manufacturing and delivery costs as part of their operations. Transportation costs can be particularly onerous because of Australia’s geographic remoteness and the size of some international trading partners.
Further challenges are created because of the increasing trend of long payment terms, with 180 days now almost standard for most international transactions.
Export finance allows sellers/exporters to receive funding against invoices raised to overseas clients. Again, the benefit this time to the seller/exporter, is that working capital is not tied-up and can be used for other business purposes.
With export finance in place, sellers/exporters can trade using open accounts, removing one of the typical barriers to international trade. There is also the option to take out export credit insurance for added security.
Export finance can be offered in conjunction with other services such as bookkeeping services and collections. Known as export factoring, such a package of services can be an excellent option for smaller or SMEs who are new to exporting.
With the world becoming increasingly interconnected, SMEs have new opportunities and face unique challenges when accessing international markets. Trade finance is an important tool in facilitating international business effectively. For both buyers/importers and sellers/exporters, trade finance helps reduce risk and assist with cash flow management and retaining access to working capital.
In conjunction with industry experts, elevateB has developed a self-paced, online, interactive Business Finance Certification. This program will provide you with the knowledge and skills required to become a successful Business Finance Professional and work in the SME space. In addition, it provides strategies and soft skills to assist you to better market and deliver your existing and new-found client offerings.
For more information on the Business Finance Certification, click here.