There are differing perceptions of what is meant by “trade finance”. Many terms are used to describe it, such as supply chain finance, trade advance, dynamic discounting, and receivables purchasing. However, the reality is trade finance applies to every transaction between a buyer and supplier. This article will look at how trade finance effects the seller.
What is Trade Finance?
Let’s look at what is trade finance. Trade is defined as “the action of buying and selling goods and services”. Unless payment is made immediately upon delivery, every trade interaction involves some form of financing. What differs is who is doing the financing and how they go about it.
Each transaction is financed by either:
- A supplier
- A buyer
- A bank or other financial lender (e.g., factor)
In the most common and simplest form, a supplier extends trade terms to the buyer, such as net 30 or 45 day terms. The supplier delivers goods and/or services to the buyer and then submits an invoice for payment. In this situation, the supplier is essentially extending a loan to buyer for 30 days or more until the invoice is paid.
This type of transaction is referred to as an “open account” transaction, where a supplier allows its customer to buy on credit without a formal borrowing agreement. There is an open or unpaid balance on the buyer’s account with the supplier, for which the supplier expects payment at a future date. The risk of default is borne by the supplier, because there is no security or formal guarantee of payment from the buyer.
Supplier Cash Flow Needs and Challenges
This structure places the credit risk burden on the shoulders of the supplier as well as the burden of effectively managing its working capital. Suppliers need to meet the cash demands of recurring business expenses, such as payroll, but face a gap between cash outlay for expenses and cash receipt from buyers. In today’s economic environment, suppliers are faced with increasing operating costs and pressure on margins, making it difficult to meet the working capital needs of the business. In addition, funding business growth, including purchasing equipment or inventory, expanding or renovating facilities, hiring staff, etc., creates even greater demands for capital.
At this point the buyer needs to bridge working capital needs through different sources of funding, including:
- Internal cash reserves
- Bank financing (commercial loans, equipment financing, lines of credit, etc.)
- Factoring the accounts receivable
- Selling equity
The old adage “Cash is king” remains true for suppliers. The availability of liquidity, predictability of cash flows, and the cost of working capital are key issues for many supplier organizations. These traditional funding sources may not be sufficient to meet all of its working capital needs. The financial crisis of 2008 and 2009 emphasized this vulnerability, as credit and liquidity markets dried up. Trade finance solutions, such as factoring, can ensure the supplier has the working capital availability in place to meet buyers request for terms and pay normal business expenses.