If you’re working in the world of export finance, you may be wondering what the difference is between trade financing and trade credit – and what the advantages are of using trade credit rather than other trade finance options.
In this article, we’ll explore the definitions of trade credit and trade finance, and why trade credit is often the best way for smaller-scale importers/exporters to do business. Let’s get started.
Trade Credit Is A Subset Of Trade Finance
The first thing that you need to understand is that trade credit is not separate from trade finance. Rather, it’s a type of trade finance. The term “Trade Finance” refers to the innumerable ways that trade, both foreign and domestic, is accomplished by importers, exporters and other businesses.
Trade credit refers to the extension of short term credit to the exporter, or to the importer of goods, or any transaction where buyers and sellers extend short term credit lines to one another. It’s essentially a short term loan that’s interest free and does not involve any financial institutions, provided by whoever is selling their goods and services.
The common “Net 30” and “Net 60” invoice terms are a good example of this. Once the goods shipped and you’ve created a bill of lading, you can invoice your customer. Then, you can give an exporter time to pay for the goods they want to buy and export, on the basis of payment in 30 or 60 days, with a 2% discount if they pay within 30 days. This type of trade financing helps improve cash flow and working capital.
The buyer has the option to pay right away and save, or to wait, if they need to acquire more funds to complete the purchase. This flexibility makes trade credit an important part of the global supply chain, and the basis for most international trade transactions.
These transactions usually involve working with a credit agency to determine a potential buyer’s credit worthiness. If you’re an exporter, for example, and cannot determine a potential customer’s credit risk, you may ask the importer’s bank or the importer to prepay for the first several shipments of goods when they open an account with your company. Then, as they show the ability to pay on time, you may extend them a longer credit line.
Trade Finance Includes Much More Than Just Trade Credit – Other Finance Options
Trade finance includes trade credit, but also a variety of other different ways by which an international or domestic trade transaction can be funded, such as:
- Letters of credit – A letter of credit is a document issued by a bank or another financial institution, and given to a product seller, on behalf of the buyer, guaranteeing payment. If the buyer does not pay, the bank does – and the buyer owes the full balance of payment to the bank.
- Bank guarantees – A bank guarantee is similar to a letter of credit. It guarantees that, in the event that either a buyer or a seller cannot fulfill their end of the bargain, the bank will pay the required dues, which helps defray risk.
- Cash With Order (CWO) – In this method of trade, the buyer of any item or items simply pre-pays for their order with cash, at the time of purchase. This is a common transaction method between companies who do not yet have a business relationship.
- Cash On Delivery (COD) – With COD, the buyer pays upon receipt of the items. This is rather rare in modern trade, for obvious reasons – the buyer could refuse to pay, not have the funds, and so on.
The Importance Of Insurance For Trade Credit Transactions
Compared to other methods of trade finance, trade credit is very simple and flexible. Giving a client an open line of credit makes routine transactions much easier – but without trade credit insurance, you could be exposing yourself to risk.
Essentially, trade credit insurance is a way to defray the risk of giving a company a line of credit. It’s a policy that guarantees that, in the event of protracted default or bankruptcy, your insured accounts receivable will be paid out, based on the compensation schedule laid out in your policy.
This way, even if your clients fail to pay for a shipment or for their goods, you can ensure that your cash flow and your profitability are protected – and that your company can continue to grow. Because of this, trade credit insurance is a very important part way to protect your company.
Learn More About Trade Finance And Trade Credit From Niche Trade Credit!
With over 15 years as a trade credit insurance broker, the team at Niche Trade Credit has seen and done it all. If you’ve got any further questions, we can help you gain a better understanding of trade finance and trade credit insurance. Contact us online now to set up an appointment.
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