coins-912718_1920A transaction, in its simplest form, is the exchange of goods between two parties: a buyer and a seller. While a local operation at the same physical location cannot be more straightforward, international trade (or any trade involving a significant distance between buyer and seller, for that matter) is more complicated and is not without its innate risks.

Trade financing, also known as import/export financing and supply chain and export financing, is all about funding international (and national) business transactions. Trade finance is considered vital to the global economy: the World Trade Organization estimates 80 to 90% of world trade (about USD 10 trillion annually) relies on trade finance as their method of financing. There are several types of trade financing, such as export insurance, issuing letters of credit, lending, and factoring.

Aside from the obvious economic benefits and increased efficiency, businesses can take advantage of the reduction of bankruptcy risks afforded by trade financing: it works by reconciling the divergent needs of an importer (buyer) and exporter (seller). Consider the risks involved in an international transaction: a buyer might refuse or delay their payment after the seller extends credit; a seller, conversely, might decide to pocket the payment and refuse shipment of the goods.

This is where trade financing comes in. Take, for instance, the most frequent type of trade financing: a letter of credit.

The letter of credit is a letter from the bank that works as a guarantee that a buyer’s payment will be received on time as soon as documented proof that the goods have been shipped is produced. Mainly, the bank acts on behalf of the buyer to ensure the completion of the transaction. In our scenario, the buyer could open a letter of credit in the seller’s name through a bank in the former’s home country. Once the bank confirms the shipping of the goods, the bank collects payment from the buyer and sends it to the seller.

Factoring, sometimes referred to as accounts receivable financing, is a transaction in which a seller sells its receivables, or invoices, to a third party commercial financial company (‘factor’). The seller then receives a cash advance, which is later collected by the factor from the buyer. The seller is paid the rest of the invoice amount, minus a fee for absorbing the collection risk. The terms, conditions and advance rates differ among industries and financial service providers, but the process is the same. The benefit of factoring is that the seller receives the cash much faster than waiting for up to 60 days for the buyer to pay.

No debt is assumed by factoring and should not be confused with taking a loan. Note that the age receivables depreciates its value: the older the receivables, the less cash the seller can expect.

This article is not intended to cover trade financing in its entirety–a comprehensive discussion of the topic could span a book or two–but we hope that it gives you an overview of how trade financing works and how it can mitigate risks in your international transactions.