What is trade finance and how does it work?

Trade finance is short-term funding tied to specific goods. It covers the gap between when you have to pay for stock or materials and when you get paid for what you sell. For importers, that gap includes weeks of shipping. For exporters, it can include making the goods, shipping them and waiting for an overseas customer to pay.

Unlike a general business loan, each drawing under a trade finance facility is usually linked to a particular purchase or order.

Import and supplier finance

This is the most common form of trade finance for Australian small and medium businesses.

How it usually works

1. You place an order with an overseas or local supplier.
2. You ask the finance provider to pay. You send the supplier’s invoice and, for imports, the shipping documents.
3. The provider pays the supplier directly, often in the supplier’s currency. The supplier is paid on time, and you may be able to negotiate better prices for paying promptly.
4. The goods arrive and you sell them.
5. You repay the provider at the end of the agreed term for that drawing, together with interest and fees.

A facility usually has an overall limit. Each drawing is a separate advance with its own term, and the limit becomes available again as you repay.

Stock and inventory finance

Stock finance is closely related. Instead of funding the purchase, the provider lends against stock you already hold, such as goods in a warehouse. It suits businesses that must carry stock for a long time before selling it, such as seasonal retailers and wholesalers.

Letters of credit

A letter of credit is a promise by a bank to pay a seller, provided the seller presents documents that match the terms set out in the letter. It is used when an overseas buyer and seller do not know each other well enough to trade on open terms.

How a letter of credit works for an importer

1. You agree a sale with an overseas supplier, who asks for a letter of credit.
2. You apply to your bank. The bank assesses you and may ask for security or a cash deposit.
3. Your bank issues the letter of credit to the supplier, usually through a bank in the supplier’s country.
4. The supplier ships the goods and presents the required documents, such as the invoice, bill of lading and packing list.
5. If the documents match the terms exactly, the bank pays the supplier, either immediately or on an agreed later date.
6. You repay the bank, either straight away or through an import finance facility that gives you time to sell the goods.

Banks check documents, not goods. A letter of credit does not guarantee the quality of what you receive. Any mismatch in the documents can delay payment, so read the terms carefully before it is issued.

For an Australian exporter, it works the other way around. Being paid under an overseas buyer’s letter of credit can reduce the risk that the buyer will not pay.

Export finance

Exporters face their own cash gap. They may need to buy materials, make the goods and ship them long before an overseas buyer pays. Options include:

• Pre-shipment or working capital finance to fund making and delivering an export order.
• Post-shipment finance that advances funds against an export invoice while you wait to be paid, which is similar to invoice finance.
• Bonds, such as advance payment or performance bonds, that an overseas buyer may require before signing a contract.

Export Finance Australia

Export Finance Australia is an Australian Government agency and describes itself as Australia’s export credit agency. It supports Australian exporters and businesses in export supply chains through loans, bonds, guarantees, and project and structured finance.

It says it works with banks and “only provide[s] finance when your bank is unable to do so”. It offers two main types of support:

• Guarantees. Export Finance Australia gives a guarantee to your bank so the bank can provide the finance you need. The bank remains your lender, and you repay the bank.
• Loans. These include term loans, revolving loans for working capital, and a Small Business Export Loan for export-related costs such as fulfilling contracts and market development. It says no property security is required for this loan, only director guarantees.

Eligibility criteria include being a company with an ACN (not a sole trader or partnership) and meeting minimum trading history and turnover requirements. Check its website for the current criteria.

Austrade also supports exporters. Its advisers help businesses assess markets and develop export strategies, and its Export Market Development Grants program encourages small and medium businesses to market and promote their goods and services overseas. A grant is not a loan and has its own eligibility rules.

How repayment usually works

Trade finance is repaid differently from a term loan.

• Each drawing has its own term. It is usually short, such as a set number of days after the supplier is paid, and is matched to how long it takes to receive and sell the goods.
• Repayment is usually a single amount at the end of the term, not regular instalments. Interest and fees are charged for the period the funds are drawn.
• The limit revolves. Once a drawing is repaid, that amount can be used again for the next order.
• Currency matters. If the supplier is paid in a foreign currency, what you repay in Australian dollars can change with the exchange rate unless you manage that risk.
• Late sales cost more. If the goods sell slowly, you may need to extend the drawing, if the provider allows it, or repay it from other funds.

Who trade finance suits

Trade finance tends to suit businesses that:

• import stock or materials and must pay suppliers before or when goods ship
• have regular, predictable stock cycles and reliable sales
• want to pay suppliers promptly to secure supply or better prices
• export and need to fund orders or give overseas buyers confidence

It is less suited to businesses that need money for wages, rent or other costs not tied to goods. A line of credit or working capital facility may be a better fit there.

Step by step

1. Map your trade cycle. Record how long it takes from paying the supplier to receiving the goods, selling them and being paid.
2. Work out the peak amount you need. Check how much is tied up at your busiest time of year.
3. Ask suppliers about terms first. Longer supplier terms may reduce or remove the need for finance.
4. Choose the right tool. Consider supplier payment finance, a letter of credit, stock finance or, for exporters, export working capital.
5. Compare total costs. Look at interest, fees per drawing, letter of credit charges and currency conversion costs, not just one headline figure.
6. If you export, check government support. Review Export Finance Australia’s eligibility criteria and Austrade’s services.
7. Talk to your accountant about currency risk, GST and customs costs on imports, and how the facility fits your cash flow.

Important things to know

• Security is usually required. Providers often take security over the goods and a general security interest over business assets, plus guarantees from directors.
• Documents must be right. Errors in shipping or letter of credit documents can delay payment and add costs.
• Currency moves can change your cost. Talk to your accountant or bank about managing exchange rate risk.
• Do not use short-term trade finance for long-term needs. Drawings fall due quickly. Using them to fund losses or fixed assets can create a repayment crunch.

Compare trade finance and stock and inventory finance options when you are ready.