Financing of Foreign Trade11th February 2020
Foreign trade financing is required especially to get funds to carry out foreign trade operations. Depending on the types and attributes of financing, there are five major methods of transactions in foreign trade. In this chapter, we will discuss the methods of transactions and finance normally utilized in foreign trade and investment operations.
Foreign Trade Payment Methods
The five major processes of transaction in foreign trade are the following −
Prepayment occurs when the payment of a debt or installment payment is done before the due date. A prepayment can include the entire balance or any upcoming part of the entire payment paid in advance of the due date. In prepayment, the borrower is obligated by a contract to pay for the due amount. Examples of prepayment include rent or loan repayments.
- Letter of Credit
A Letter of Credit is a letter from a bank that guarantees that the payment due by the buyer to a seller will be made timely and for the given amount. In case the buyer cannot make payment, the bank will cover the entire or remaining portion of the payment.
- Sight Draft − It is a kind of bill of exchange, where the exporter owns the title to the transported goods until the importer acknowledges and pays for them. Sight drafts are usually found in case of air shipments and ocean shipments for financing the transactions of goods in case of foreign trade.
- Time Draft − It is a type of foreign check guaranteed by the bank. However, it is not payable in full until the duration of time after it is obtained and accepted. In fact, time drafts are a short-term credit vehicle used for financing goods’ transactions in foreign trade.
It is an arrangement to leave the goods in the possession of another party to sell. Typically, the party that sells receives a good percentage of the sale. Consignments are used to sell a variety of products including artwork, clothing, books, etc. Recently, consignment dealers have become quite trendy, such as those offering specialty items, infant clothing, and luxurious fashion items.
- Open Account
Open account is a method of making payments for various trade transactions. In this arrangement, the supplier ships the goods to the buyer. After receiving and checking the concerned shipping documents, the buyer credits the supplier’s account in their own books with the required invoice amount.
The account is then usually settled periodically; say monthly, by sending bank drafts by the buyer, or arranging through wire transfers and air mails in favor of the exporter.
Trade Finance Methods
The most popular trade financing methods are the following:
- Accounts Receivable Financing
It is a special type of asset-financing arrangement. In such an arrangement, a company utilizes the receivables – the money owed by the customers as a collateral in getting a finance.
In this type of financing, the company gets an amount that is a reduced value of the total receivables owed by customers. The time-frame of the receivables exert a large influence on the amount of financing. For older receivables, the company will get less financing. It is also, sometimes, referred to as “factoring”.
- Letters of Credit
As mentioned earlier, Letters of Credit are one of the oldest methods of trade financing.
- Banker’s Acceptance
A banker’s acceptance (BA) is a short-term debt instrument that is issued by a firm that guarantees payment by a commercial bank. BAs are used by firms as a part of the commercial transaction. These instruments are like T-Bills and are often used in case of money market funds.
BAs are also traded at a discount from the actual face value on the secondary market. This is an advantage because the BA is not required to be held until maturity. BAs are regular instruments that are used in foreign trade.
- Working Capital Finance
Working capital finance is a process termed as the capital of a business and is used in its daily trading operations. It is calculated as the current assets minus the current liabilities. For many firms, this is fully made up of trade debtors (bills outstanding) and the trade creditors (the bills the firm needs to pay).
Forfaiting is the purchase of the amount importers owe the exporter at a discounted value by paying cash. The forfaiter that is the buyer of the receivables then becomes the party the importer is obligated to pay the debt.
It is a form of foreign trade where goods are exchanged for other goods, in place of hard currency. Countertrade is classified into three major categories: barter, counter-purchase, and offset.
- Barter is the oldest countertrade process. It involves the direct receipt and offer of goods and services having an equivalent value.
- In a counter-purchase, the foreign seller contractually accepts to buy the goods or services obtained from the buyer’s nation for a defined amount.
- In an offset arrangement, the seller assists in marketing the products manufactured in the buying country. It may also allow a portion of the assembly of the exported products for the manufacturers to carry out in the buying country. This is often practiced in the aerospace and defense industries.