HK
HK
1.
Letter of Credit (LC) - A bank guarantee ensuring the seller gets paid if they meet the agreed-upon terms, providing security for both buyer and seller in international trade.
2.
Purchase Order (PO) Finance - A method used to cover procurement costs from suppliers issued by the buyers. This helps buyers with limited capital grow their sales.
3.
Supply Chain Finance - A financing solution that offers suppliers advance payment and allows buyers to negotiate better payment terms.
Over 80 percent of global trade relies on trade finance or credit insurance for a reason.
Why? Because it helps businesses handle their risks properly, ensure the smooth flow of transactions, and avoid any cash flow imbalances.
This article will explain all you need to know about trade finance products, including what they are, how each type works, their features, and how they can benefit your business.
Trade finance products are financial tools designed to facilitate international trade transactions. They address common challenges, such as non-payment and cash flow gaps, ensuring a secure and successful experience for both importers and exporters.
Here's how they can help your business.
Several types of trade finance products are available in the market. However, we will focus on the 3 most common types: Letter of Credit (LC), Purchase Order (PO) Finance, and Supply Chain Finance (SCF).
| Letter of Credit | Purchase Order Finance | Supply Chain Finance | |
|---|---|---|---|
| Function | Guarantee payment | Provides upfront capital for large orders | Improves cash flow for buyers & sellers |
| Best for | High-security, risky international deals | Businesses needing cash upfront for large order volumes | Businesses seeking better terms with suppliers |
| Security | High (guaranteed by the bank) | Moderate (depends on buyer's credit) | Varies (improves overall financial stability) |
| Cost | Expensive (bank fees and lots of paperwork) | Moderate (interest & fees) | Generally low |
A letter of credit is a bank-issued guarantee for the seller (exporter) to receive payment if they meet the agreed-upon terms of the sale.
Essentially, it represents a commitment from the bank to pay the exporter within a specified timeframe, based on negotiated conditions.
Important: Banks typically require a deposit or collateral to issue LCs, ensuring they're protected if something goes wrong.
While there are various types of Letters of Credit (LCs), here are the most common ones among international traders:
Usually, when the importer (buyer) wants to purchase products from an exporter (seller), the buyer will reach out to their bank along with a purchase order to request the Letter of Credit.
Depending on their credibility, the bank will issue the LC. Then the importer’s bank will send the LC to the exporter’s bank.
As soon as the exporters receive the letter and verify the terms, they will clear the bank, and the goods will be ready to be shipped.
After that, the seller’s bank will issue the payment to the seller. Then, the buyer’s bank will receive the forwarded shipping papers, and the importer will request the payment.
Note: The process can be time-consuming and requires careful compliance with detailed documents. Also, once issued, changes are difficult and expensive.
There are many benefits when using a Letter of Credit as your trade finance product, such as:
Purchase Order (PO) finance is designed for SMEs who face inefficacy or cash flow problems.
This is part of the pre-shipment solutions for trade finance.
Essentially, it provides capital to pay suppliers with the verified purchase order to guarantee smooth cash flow. It enables businesses to accept a large volume of orders and adjust the loan amount to meet their needs.
It’s especially true for SMEs as most of the time they receive a large volume of orders but don’t have enough working capital to process them. It solves exactly that problem.
PO finance advances to a certain percentage by the financial institution, usually 30-70% of the purchase order amount.
Even if the volume of orders decreases, there are no tied arrangements, which means you can stop using it anytime you want.
If your business is considering PO finance for more flexible cash flow, here are a few of the simple requirements you should pay attention to:
Tip: Lenders focus on three major factors for PO Finance qualification: the size of the order, the creditworthiness of the customer, and the profit made on high-volume orders.
Once you have a verified purchase order, you can apply for PO financing. Then, the financing provider will assess your business and the legitimacy of the order.
If approved, the financing provider will pay your supplier directly, covering a significant portion of the order value. With the supplier paid, you can now focus on fulfilling the order without worrying about cash flow.
Once your customer pays you, you can use those funds to repay the financing provider, along with any applicable fees and interest.
Using PO finance as part of your pre-shipment solutions can offer plenty of benefits, which are:
Increased Sales and Inventory: The ability to grow sales and maintain more inventory even when you're limited by capital.
The main goal of Supply Chain Finance is to improve the payment terms and make your cash flow more flexible in the supply chain process.
The buyer would negotiate payment terms, including an extended payment schedule.
At the same time, the seller can also get immediate payment while quickly unloading the products.
In essence, it's a win-win for everyone in the supply chain – you (the seller), your buyers, and even the financial institution involved.
Now, we should clarify this one thing first: supply chain finance is not a loan per se.
In fact, it is a technology-based cash flow solution that lowers financial costs for both parties.
The good thing about it is that it frees up some of your working capital while you wait for the shipment to arrive.
So your money won’t get trapped in the supply chain and make your cash flow more flexible.
After the supplier delivers goods or services and sends an invoice to the buyer, the buyer verifies the invoice and approves it for financing.
Upon verifying the invoice, the buyer approves it for financing. A financial institution then steps in, paying the supplier a significant portion of the invoice amount on behalf of the buyer minus a small fee or discount.
On the original due date, the buyer pays the financial institution the full invoice amount.
Note: Typically, lenders calculate fees based on the buyer’s credit, as they are ultimately responsible for repaying the full invoice amount.
There are two major individuals involved when it comes to SCF - a supplier and a buyer.
For Suppliers:
For Buyers:
The good thing about trade finance and its products is that it can unlock capital from your business’s existing stock or receivables based on the trade cycles in your company - the key point is to reduce your payment gaps.
By reducing these gaps, you can significantly minimize exchange rate risks and maximize the efficiency of your trading cycle.
