Trade finance is a term which collectively defines the process of providing financial support several functions connected to International commerce and trade. International trade finance includes activities such as financing the trade for the buyer and seller, factoring invoices, short term export credit,issuing letters of credit and insurance. Insurance companies, banks, credit agencies, finance agencies are the companies involved in trade financing.
Trade finances are usually short term which provides capital at less interest rates, insurances at cheaper costs which covers both the buyer and seller in case of emergency situations, banks providing short term loans with letter of credit as a guarantee certificate. World Trade Organisation estimates that almost 85-90 percent of World trade relies on trade financing. Key factors which covers trade financing are explained below.
Letter of Credit:
When both buyer and seller are from a different countries and when they are not sure about the trust factor of both the parties, both of them could issue a letter of credit guaranteed by their bank, authenticating the creditworthiness of both their parties. A buyer/seller could go to his bank and ask for a letter of credit. The bank will check the credit score and they can issue a letter of credit based on his creditworthiness or they can ask their party to deposit certain amount of money and provide the letter of credit. Buyer/Seller could provide it to their other party, stating that in case of undesirable events, if either of the party could not pay or deliver the services or goods, their bank would guarantee the payment which was promised by their respective client.
When both the buyer and seller are from different countries which incur different risks including political, transportation, natural calamities, bankruptcy of buyer or seller, agitation or emergency situation in the country of buyer or seller. Trade insurances cover the risk of all possible vulnerabilities which could affect the buyer or seller at cheaper costs in comparison to the risk and value of goods exported.
Banks provide short term loans, for both the buyer and seller at cheap interest rates for international trade finance, as the volume is high, and the payback time is too short, which is usually a quarter or two. Banks also provide loans to a seller with letter of credit from buyer as a security document.
Factoring provides the service of convertibles to received. When the seller is suffering with lack of liquidation, the seller could use the invoices raised to his buyer, and go to a factoring agency and get paid from the factoring agency for the invoices he owes money from the buyer. The factoring agency will take care of the follow up with the buyer and take care of getting the payments from buyer. Although there will be a percentage of service charge incurred by the factoring agency, but it greatly helps the companies which suffers lack of liquidation to get the instant cashflow for operational purposes.
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