Is Trade Finance worth the cost?
For those SME's that deal with suppliers with either long lead times, various geographical locations or other complexities, financing the purchase of goods can be a challenge.
Beyond the options of using cash reserves or other traditional debt facilities, trade finance can be a viable option in multiple scenarios.
What is it?
Trade finance is a type of working capital facility. Typically it is used to support the time between the purchase of inventories, and the ultimate sale of goods and collection of payment from the customer. These terms can range from 30 days up to 120 days with some financiers.
It is typically associated with purchasing goods from overseas. However, it is not limited to this and can be for local supplier arrangements too.
It usually works as a line of credit or limit facility, with repayment terms that allow the deferral of payment for goods until they are sold.
Who should use it?
Like all working capital facilities, SMEs need to ensure that there is a match between their funding need, and the structure of their facilities. For example, too often we see business use short term funding for long term assets or vice-versa. This can be an expense exercise.
So you must understand your cashflows intimately before jumping in.
Put together well, using a funding mechanism like this can be great for growing businesses. It means your business has the cash flow to increase purchasing ability, enabling more stock acquisition to grow sales volumes.
What is required?
Beyond the traditional commercial financial information, there is a greater focus on Debtors and Creditors Ageing, Contracts and Supply Agreements. Insurance of the goods between shipment and pay down of the facility delivery is required, as often this is the financier's effective security.
So it is important that this is in order.
Like any working capital facility, where it is not otherwise supported by other collateral such as property, the relative cost isn't cheap (especially in the context of the current low borrowing cost environment) and the structure of how it is charged is more complicated.
Of course, where the loan or credit limit is relatively small, the interest rate may not be material. Though be prepared for a structure that includes:
- Establishment Fee (as a set $ amount)
- Management Fee (as a % of each trade transaction)
- Line Fee (as a % of the total Trade $ outstanding)
As a result, the effective cost will depend on the size and timing of transaction drive the overall costs. Outside major banks, this may end up costing more than a traditional overdraft. As a rough guide this may look like an all up cost of say 12.5% - 17.5%.
Some good financial forecasting is crucial. If you do not understand your working capital cycle, talk to someone that does. Short term and pressured decisions in relation to financing, tend to be less optimal ones.