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Trade finance versus trade credit

M S Siddiqui
08 Feb 2023 00:02:36 | Update: 08 Feb 2023 00:02:36
Trade finance versus trade credit

Financing is the process of providing funds for business activities, making purchases or investing. Financial institutions such as banks are in the business of providing capital to businesses to help them achieve their goals. The financing is available in form of trade finance and trade credit. Trade credit is extending by Banks while trade credit is extending by seller or business counterpart. The trade finance and trade credit is confusing words to many in the stakeholders and the terms are used interchangeably. 

The Bank for International Settlements describes in their paper “Trade finance: developments and issues”. The term “trade finance” is generally reserved for bank products that are specifically linked to underlying international trade transactions (exports or imports). As such, a working capital loan not specifically tied to trade is generally not included in this definition. Trade finance products typically carry short-term maturities, though trade in capital goods may be supported by longer-term credits.

FIs usually finance international trade of Import and Export through a wide range of financial products that help their customers manage their international payments and associated risks, and provide needed a part of working capital.    These products like Letters of Credit, specific trade loans tied to letters of credit, supply chain finance, factoring, invoice discounting, etc.

On the other hand, Trade Credit is inter-firm trade credit between buyers and sellers.  Banks tend to refer to this type of international trade as open account transactions, where goods are shipped in advance of payment, and cash-in-advance transactions, where payment is made before shipment.

A trade credit is an agreement or understanding between agents engaged in business with each other that allows the exchange of goods and services without any immediate exchange of money. When the seller of goods or service allows the buyer to pay for the goods or service at a later date, the seller is said to extend credit to the buyer. Most companies finance the buyer by providing goods and services to Buyers is a form of a loan to the Buyers. This loan, or Trade Credit, can be the largest user of capital for most businesses.  The is a most interest free and flexible funding for their customers. The fund also is in fact a credit from banks to the seller in the form of financing corporate trade.

Trade credit allows businesses to receive goods or services in exchange for a promise to pay the supplier within a set amount of time. New businesses often have trouble securing financing from traditional lenders. Buying inventory and trade credit is primary finance for newcomers. Suppliers who agree to invoice customers may benefit from larger contracts and new partnerships. Trade credit extended to a customer by a firm appears as accounts receivable and trade credit extended to a firm by its suppliers appears as accounts payable. Trade credit can also be thought of as a form of short-term debt which doesn’t have any interest associated with it.

Trade finance is a wide form of credit from Banks such as finance the export or import goods in both domestic and international markets. Trade finance includes import and export finance, invoice discounting and invoice factoring, and business loans.

The traditional trade finance usually involves Letters of Credit or Documentary Collections, which is guaranteed with the stock or goods in transit act as the security and export proceeds etc.

Trade credit is essentially a short-term indirect loan. When a supplier delivers goods to a buyer and agrees to accept payment later, the supplier is essentially financing the purchase for the buyer.

Trade credit is an interest-free loan. As long as the buyer hold the payment, the buyer is saving the money that would have been spent on interest to finance the purchase with a loan. At the same time, the supplier is losing the interest it would have earned had it received the payment and invested the cash. Therefore, the buyer wants to postpone payment as long as possible and the supplier wants to collect payment as soon as possible. That is why suppliers often offer discount credit terms to buyers who pay sooner rather than later.

A trade credit is a B2B agreement in which a customer can purchase goods on account without paying cash up front but paying the supplier at a later date. Usually when the goods are delivered, a trade credit is given for a specific number of days, say 30, 60 or 90 days.

Such favorable terms effectively reduce the pressure on cash flow that immediate payment would make. This kind of financing is helpful in minimizing and managing the capital requirements of an enterprise.

Many large companies borrow more from suppliers through trade credit than from their banks. Trade credit for Wal-Mart is eight times the amount of capital invested by shareholders. Small and medium-sized businesses often complain that giant companies abuse trade credit facilities by dragging their feet with late payments.

The principal alternative to bank trade finance is credit between inter-firm involved in local or international trade. The trade credit in international trade is open account transactions, where goods are shipped in advance of payment, and cash-in-advance transactions, where payment is made before shipment. Inter-firm trade credit entails lower fees and more flexibility than trade finance. This option is most beneficial to the importer in terms of cash flow and cost, and thus represents the highest risk for the exporter, who is exposed to non-payment risk.

In a cash-in-advance transaction, the importer pays the exporter upfront, and the associated cash flow and settlement risks are reversed. The latter option is less frequently used. The reliance on inter-firm trade credit is more likely among firms that have well established commercial relations, form part of the same multinational corporation and/or are in jurisdictions that have reliable legal frameworks for collection of receivables. In open-account transactions, the exporter extends credit to the importer by shipping and delivering goods before payments are due (usually 30 to 90 days).

The seller’s ability to extend trade credit is supported by possibilities to discount their receivables, e.g. via factoring, and the availability of financing from banks and capital markets not directly tied to trade transactions. Firms can also mitigate payment risk by purchasing trade credit insurance.

A seller’s capacity to extend trade credit can be underpinned by the option, where available, to discount receivables, for example via ‘factoring’, and by access to bank and capital market finance that is not tied directly to trade transactions. Sellers can further reduce payment risk by purchasing trade credit insurance. Trade credit insurance is also used by banks to hedge their own payment risks.

Inter-firm trade credit offers lower fees and more flexibility than bank-intermediated products. It leaves firms bearing more payment risk, however, and implies a potentially greater need for working capital. Inter-firm credit is more likely among firms that have well established commercial relations and/or operate in jurisdictions that have reliable legal frameworks for the collection of receivables. Exporters’ ability to extend credit to importers can be enabled by receipt of inter-firm trade credit from their domestic and international suppliers, as well as the option to discount receivables (e.g. via factoring and discounting). The availability of financing from banks and capital markets that is not tied to trade transactions also enables firms to extend trade credit to their clients.

Given the expanding role of global multinational corporations, a growing share of inter-firm trade credit is related to trade between two affiliated companies, where such considerations are less important than the management of the companies’ cash flows.

Trade credit is a very risky transaction in Bangladesh as enforceable of contract is very weak as there is no easy administrative and legal remedy of breach of contract, delay of payment or non-payment, etc. The ADR system is also not of global standard and usually bias against weaker party. In the volatile financial sector unable to provide sufficient fund to the business and local business are financed by business counterpart. But the trade finance in international trade is part of international law and practice. Bangladesh is lacking in adapted those law and rules and also has limitation due to poor enforcement of contracts without lengthy and complicated court system.

The writer is Non-Government Adviser, Bangladesh Competition Commission and CEO, Bangla Chemical. He can be contacted at [email protected]