The Role of Trade Finance in Working Capitaldocuments to the importer’s bank, which will
also examine the documents. If satisfied, the
importer’s bank will release the documents to
the importer (including any documents of title)
in exchange for payment or the acceptance
of a bill of exchange. The importer’s bank
will pay the exporter’s bank direct (or via a
negotiating bank, if there is an extra bank in
the chain to purchase or negotiate documents
presented by the exporter). The exporter’s
bank will then pay the exporter (if payment
has not already been made).
Risks and advantages for buyers/importers
Compared with open account trading and
documentary collections, documentary credits
shift the balance of assumption of risk towards
the importer. This is because, as long as the
terms of the letter of credit are met by the
exporter, the importer is required to pay.
Banks play an important role in the
documentary credit process; however,
their role is solely linked to the checking of
documents. Banks do not check the goods
themselves. This can result in importers
being forced to pay even when goods are
damaged in transit or the wrong type have
been shipped, as long as the exporter has
met the terms of the letter of credit associated
with the transaction.
Because a letter of credit represents
a financial commitment on the part of the
importer to pay, the importer will need to
arrange an appropriate credit facility with the
bank arranging the letters of credit, before
one can be issued. This facility will normally
place a restriction on the time and number
of letters of credit outstanding at any one
time. In turn, this places a constraint on the
quantity of goods which the importer can
purchase at any one time without amending
such a facility. The cost of a letter of credit
is based on a percentage of its amount and
tenor, and any resultant drawing.Case study
UK provider of workwear for large UK corporations
A UK SME sources and imports manufactured workwear for large UK
corporations. Large corporations tend to change employee workwear about
every 12 months. The provider has to source the workwear, arrange a supplier
and deliver the finished workwear to the corporation within a three to four-month
cycle. The cost of manufacture is approximately GBP 1.5–2 million per cycle.
Because the importer is an SME, it does
not have access to sufficient cash to cover
the requirement for this three to four-
month cycle. However, because it holds
a confirmed purchase order from a UK
blue chip company, banks are prepared to
finance the importer.
Before offering finance, the importer’s
bank needed to understand the importer’s
business cycle. This process included
identifying the point at which the
goods become available, the payment
mechanism(s) used to pay the supplier,
and the time frame within which the blue
chip client pays in the UK.
Once the bank understood the business,
it offered financing in the form of import
letters of credit, supported by import loans.
This provided assurance to the supplier
that it will be paid. The importer is then
required to repay the import loans when
funds are received from the blue chip
company, according to the agreed payment
terms of 60 days after date of delivery.