Various tools are at businesses’ disposal for financing their international trade. Each has advantages and disadvantages for trade import-export, and businesses must determine which is best for their particular needs and the circumstances of a given international transaction. This article briefly looks at some of the available tools and solutions.
Accounts Receivable Financing for International Trade Deals
Accounts receivable financing is an asset-based financing method where a business uses its accounts receivable as collateral for a loan. If the business is unable to repay the borrowed funds, the financing company can seek to collect the accounts receivables against the amount of the loan. Accounts receivable financing is a popular method utilized in international trade, having been first developed in ancient Mesopotamia.1 With over US$1 trillion outstanding globally in accounts receivable financing, it is one of the most reliable and efficient methods for businesses to finance their operations, especially when engaging in international trade.
Factoring for Import-Export
Factoring, sometimes called debtor financing or receivables factoring, is more common for domestic trade financing but also is used for international trade finance. In factoring, a financing company (called the “factor”) purchases accounts receivables from a business, generally paying between 80 and 90 percent of their value (although for some businesses this can drop to as low as 70 percent). The business receives an amount lower than the receivables’ face value, but they receive it now instead of several months later. The financing company must pursue payment from the businesss’ customers.2 The balance of the value (the 10 to 30 percent not advanced by the factor), less the factoring fee, is paid to the business when the invoices are collected. The factoring fee, which is based on the total value of the invoices typically ranges from 1.5 percent to 5.5 percent, depending on such variables as the collection risk and how many days the funds are in use.3
Letters of Credit: Strictly for International Trade
A letter of credit is used in international trade to resolve the dilemma of businesses trying to sell to customers in foreign countries with reasonable assurance that they will receive payment. For example, a manufacturer in the United States sells US$1,000,000 worth of machinery to a customer in Greece. But the manufacturer wants to be certain that the customer will pay the invoice before delivering the valuable machinery. The customer in Greece, conversely, wants to see the machinery safely delivered before paying the US$1,000,000. To resolve this, the customer gives its bank US$1,000,000 and the Greek bank sends the manufacturer’s bank in the United States a letter of credit, which is essentially a guarantee that the manufacturer’s bank will be paid the US$1,000,000 once the machinery is delivered to the customer in Greece.4
Banker’s Acceptance for International Trade
Banker’s acceptances are popular in import-export transactions, often linked to a specific international transaction, such as the purchase of a large amount of supplies or equipment (i.e., purchasing aircraft) or a large project (i.e., building a new factory). A banker’s acceptance is like a post-dated a check: it’s a short-term debt instrument drawn on a bank deposit that provides a bearer the right to be paid the noted amount on a future date, generally 30-to-180 days from issuance. But it’s guaranteed by the bank, so its creditworthiness is judged by the reputation of the bank, not the business. Banker’s acceptances are generally regarded as low-risk debt. They can be traded on secondary debt markets and are commonly traded and held by money market funds.5
International Trade via Working Capital Financing
Working capital financing, often referred to as working capital loans, are short-term debt instruments used to finance the day-to-day operations of a business. It also allows exporters to purchase the goods and services they need in order to support their export sales.6 Unlike loans with longer maturity dates, working capital loans are not used to purchase capital assets (i.e., buildings or machinery); they’re used to pay utility bills, payroll obligations, fuel costs, and other similar short term obligations.7 Working capital financing is generally useful for businesses with more cyclical or seasonal cycles, where sales revenue might spike at certain times of the year out-of-sync with the business’ fixed costs. For example, a business which exports Christmas trees may be faced with eleven months of costs to nurture and grow the trees, but receive all of its revenue in the twelfth month. Overall, there is approximatley US$6.5 to US$8 trillion in working capital finance used for international trade.8
There are numerous tools available to businesses to help them develop their international trade portfolio, expanding their horizons to new markets. Each solution has its advantages, and often the best option is a tailored solution consisting of a combination of multiple financing tools.