Home / Glossary / What is trade finance?

What is trade finance?

Trade finance is the term used to describe the tools, techniques, and instruments that facilitate trade and protect both buyers and sellers from trade-related risks. The purpose of trade finance is to make it easier for businesses to transact with each other. It also helps to reduce the risks involved in global trade, for both buyers and sellers.

How does trade finance work?

When a trade transaction takes place, the buyer and seller incur different types of risk. For the buyer, there is a risk that the goods purchased will not arrive on time or will fall short of the expected quality or volume. The seller, meanwhile, faces the risk that payment will not be received on the agreed terms for the goods provided.

These risks are exacerbated in an international trade transaction, as resolving any disputes can be time consuming and difficult – particularly when the markets involved have different cultures and regulatory climates.

To mitigate these risks, there are different ways of structuring trade transactions, including open account, payment in advance and letters of credit.

Open account

The simplest and most common way of structuring a trade finance agreement is with open account terms, whereby the buyer (importer) pays for goods after they have been received. This protects the buyer from the risk of paying for goods that do not meet required standards, but does not protect the seller (exporter). As such, open account terms are only recommended for trusted or low-risk trading relationships.

That said, the risk associated with open account transactions can be mitigated using trade finance techniques such as export credit insurance. Another option is factoring, a receivables financing technique whereby suppliers sell their accounts receivable to a factor, which then takes on the responsibility for obtaining outstanding payments.

Supply chain finance is another type of solution used to finance receivables, but unlike factoring it is initiated by the buyer rather than the supplier. The cost of finance is based on the buyer’s credit rating rather than the suppliers, meaning that suppliers typically receive funding at a more favorable rate.

Payment in advance

At the opposite end of the spectrum to open account terms is payment in advance (or cash in advance), whereby the buyer pays the supplier before goods have been received. While this trade finance method protects the supplier from the risk of non-payment, it does not protect the buyer from the risk that goods will not be received on time and as expected.

Letters of credit

In other cases, transactions may be structured around different trade finance techniques. These include letters of credit (LCs or L/Cs), which are often used to guarantee and finance international trade, particularly in higher-risk transactions. The use of LCs is governed by rules published by the International Chamber of Commerce, known as the Uniform Customs and Practice for Documentary Credits. The current version, UCP 600, came into effect on 1st July 2007.

In a letter of credit transaction, the buyer’s bank provides a letter guaranteeing that the seller will be paid in full and on time, as long as the necessary documentary conditions are met. The documents required may include bills of lading, insurance certificates and commercial invoices. If the buyer is unable to make the payment, the bank will pay on the buyer’s behalf.

As such, trade risks are mitigated for both the buyer and seller. The seller receives a guarantee that they will receive payment as long as goods are received as agreed, while the risk to the buyer is addressed by the need for documentary proof that goods have been received. However, LCs also have some drawbacks: they can be costly to arrange, and documentary requirements and bureaucracy can result in considerable delays.

Many different types of LC are used in international trade, including:

  • Confirmed letter of credit – a letter of credit which includes an additional guarantee of payment from a second bank (the confirming bank).
  • Revolving letter of credit – a single letter of credit that can be used to cover multiple transactions over a period of time.
  • Standby letter of credit – a letter of credit that provides assurance the buyer is able to pay the buyer, in the expectation that the LC will not need to be used.
  • Back-to-back letter of credit – two letters of credit used to connect the buyer and seller via an intermediary.
  • Sight letter of credit – payment is made immediately once the necessary documents have been reviewed by the bank.

Documentary collection

Documentary collection is similar to a letter of credit, in that documents are presented to the buyer’s bank before the seller is paid. However, a key difference is that the buyer has the right to reject the goods provided. Documentary collection is also a less expensive trade finance technique than a letter of credit.

Trade finance gap

Trade finance plays an important part in facilitating global trade. However, according to the Asian Development Bank, unmet demand means there is a trade finance gap of as much as $1.5 trillion, with smaller businesses disproportionately affected.

Developments such as blockchain and distributed ledger technology may play a role in facilitating trade finance transactions in the future. In addition, solutions like supply chain finance can play an important role in helping suppliers access the finance they need to do business.

Benefits of trade finance

As well as mitigating the risk inherent in certain trade transactions, such as the risk of nonpayment, trade finance can also enable sellers to access the short-term finance they need to do business. As such, it plays an important role in facilitating international trade, improving cash flow and supporting business growth.

Accounts receivable automation (or AR automation) is the practice of automating parts of the accounts receivable process in a business. Learn more here.
Flexible Funding is a feature for Taulia Payables that allows buyer organizations to use the right funding at the right time. It gives corporate treasurers options to meet their short-term cash flow needs without restricting the liquidity suppliers rely on.
A working capital funding gap is the difference between short term assets and short-term liabilities. Learn everything you need to know about funding gaps here.
The accounts receivable (AR) process is the series of actions businesses carry out to collect their accounts receivable. Learn more about it here.
The accounts receivable (AR) process is the series of actions businesses carry out to collect their accounts receivable. Learn more about it here.
Accounts receivable factoring is a way for businesses to secure financing by selling their unpaid invoices for cash. Learn more in our glossary post.
Debt financing allows businesses to borrow money to fund their short-term needs. Get a full definition and explanation in our guide to debt finance.
Working capital funding, also known as working capital financing, is a method of business financing. Learn more about the types of working capital funding here.
Integrated ERP systems refers to the combination of an ERP with integrated modules that can help you manage diverse business processes from one platform.
Lean supply chains are designed to maximize efficiency. Learn all about the principles of lean supply chain management in our glossary entry.
Learn everything you need to know about supplier segmentation, including what supplier segmentation model to use and how to tackle the process, in our guide.
What is ESG? ESG stands for environmental, social and governance. Together, these three principles form a framework that’s used to measure how sustainably, ethically, and responsibly an organization is acting. ESG is most often used to describe the efforts companies take to mitigate the potential negative outcomes of their operations. It also refers to a…
What is supply chain management? Supply chain management (SCM) describes the process businesses use to manage the flow of goods, data, and payments throughout a supply chain. Effective supply chain management is instrumental in ensuring every element of the supply chain works towards achieving broader business objectives, whether that’s cost-efficiency, resilience, quick order fulfillment, or…
What is supply chain optimization? Supply chain optimization is the process of refining the structure and operation of a supply chain. It aims to make the best use of resources and technology to extract greater efficiency and performance from the supply chain network. Well-optimized supply chains enable businesses to meet their broader objectives, whether that’s…
What is accounts receivable? Accounts receivable (AR) is the term used to describe money owed to a business by its customers for purchases made on credit. It’s listed as a current asset on the balance sheet, representing the total value of outstanding invoices for products or services sold but not yet paid for. Total accounts…
What is cash flow management? Cash flow management is the process of optimizing the flow of money in and out of a business to achieve a specific operational aim. Effective cash flow management enables businesses to use their working capital better and fuel growth or build resilience. It involves using several levers, including the approach…
What is strategic sourcing? Strategic sourcing is the term used to describe a strategic approach to the sourcing process. It involves the same fundamental steps – research, analysis, negotiation, contracting, and onboarding of new suppliers to fulfill demand for goods or services – but is oriented to contribute to broader business objectives. It also often…
What is automated spend analysis? Automated spend analysis is an automatic digital process that captures, consolidates, and interprets spend data across an organization. It’s used to provide insights into spend efficiency and effectiveness, informing sourcing and purchasing decisions. It’s typically facilitated through dedicated automated spend analysis software, usually integrated with a wider enterprise resource planning…
What is the new FASB accounting treatment for supply chain finance? In September 2022, the Financial Accounting Standards Board (FASB) — the governing body for accounting standards in the United States — updated its standards to include a requirement for SCF disclosure on company financial statements. For most organizations, disclosure of an existing SCF program…
What is spend visibility? Spend visibility refers to how well a company can understand and track how, where, and why capital is used in their business operations. Spend visibility increases when finance teams can more accurately see where company money is being spent. Low spend visibility is defined by difficulties tracking spend comprehensively or accurately….
What is 2/10 net 30? 2/10 net 30 is a trade credit often offered by suppliers to buyers. It represents an agreement that the buyer will receive a 2% discount on the net invoice amount if they pay within 10 days. Otherwise, the full invoice amount is due within 30 days. It’s one of the…
What is working capital ratio? Working capital ratio is a measurement that shows a business’s current assets as a proportion of its liabilities. It’s a metric that provides an overview of financial health and liquidity, indicating whether current liabilities can be paid by existing assets. In the case of working capital ratio, assets are typically…
What is a virtual card? A virtual card is a payment method that is virtual rather than physical. It functions similarly to a traditional credit card but takes the form of a single-use 16-digit number and three-digit CVV code generated online, instead of a plastic or metal card that is received through the post. Virtual…
What is e-procurement? E-procurement refers to the set of digital processes that dictate B2B buyer-supplier relationships in the supply chain. Utilizing technology, e-procurement aims to centralize the workflows involved in purchasing goods or services and bring about efficiency improvements. It’s essentially the digitization of the standard procurement process. E-procurement, short for electronic procurement, replaces traditional…
What is source-to-pay? Source-to-pay (or S2P) is the process that outlines how organizations fulfill their sourcing and procurement needs. It begins with the identification of demand for a product or service, encompasses steps including supplier selection, contract management, and requisition, and ends with a payment being made. It can be split into two composite sections:…
What is supplier relationship management? Supplier relationship management is the set of processes that organizations use to build, manage, and maintain relationships with their suppliers, or vendors. A supplier relationship management strategy is essential to ensure that relationships are built productively, with a view to increasing the overall effectiveness and resilience of the supply chain….
What is supplier information management? Supplier information management (SIM) refers to the set of processes or the system that organizations use to collect, store, access, and update important data about their suppliers. From contact details to contractual documentation, the data involved in supplier information management is essential in the broader process of vendor management. A…
What is AP automation? AP automation, short for accounts payable automation, is the use of software to automate part or all of the accounts payable process. It aims to create efficiency in the accounts payable workflow by digitizing how vendor invoices are received, processed, and stored. In removing manual processes and the need for paper-based…
What is accounts payable? Accounts payable (AP) represents the amount that a company owes to its creditors and suppliers (also referred to as a current liability account). Accounts payable is recorded on the balance sheet under current liabilities. When a business purchases goods or services from a supplier on credit, payment isn’t made straight away,…
What is accounts receivable (AR) financing? Accounts receivable or AR financing is a type of financing arrangement which is based on a company receiving financing capital in return for a chosen portion of its accounts receivable. An AR financing arrangement can be structured in several ways, including as an asset sale or a loan. Essentially,…
What is the cash conversion cycle (CCC)? The cash conversion cycle (CCC) – also known as the cash cycle – is a metric expressing how many days it takes a company to convert the cash it spends on inventory back into cash by selling its product. The shorter a company’s CCC, the less time it…
What is cash flow forecasting? Cash flow forecasting, also known as cash forecasting, estimates the expected flow of cash coming in and out of your business, across all areas, over a given period of time. A short-term cash forecast may cover the next 30 days and can be used to identify any funding needs or…
What is Days Inventory Outstanding? (DIO) Days inventory outstanding (DIO) is a working capital management ratio that measures the average number of days that a company holds inventory for before turning it into sales. The lower the figure, the shorter the period that cash is tied up in inventory and the lower the risk that…
What is Days Payable Outstanding? (DPO) Days payable outstanding (DPO) is a useful working capital ratio used in finance departments that measures how many days, on average, it takes a company to pay its suppliers. As such, DPO is an important consideration when it comes to managing a company’s accounts payable – in other words,…
What is Days Sales Outstanding? (DSO) Days sales outstanding (DSO) is a working capital ratio which measures the number of days that a company takes, on average, to collect its accounts receivable. The shorter the DSO, the faster the company collects payment from its customers – and the sooner it is able to make use…
What is dynamic discounting? Dynamic discounting is a solution that provides suppliers with the option of receiving early payment in exchange for a discount on their invoice. As a result, suppliers can typically access lower cost funding than they might otherwise receive, while harnessing working capital in order to invest in growth and innovation. Buyers, meanwhile,…
What is an early payment discount? An early payment discount is a form of trade finance, allowing buyers to pay a discounted amount to suppliers in exchange for settling invoices before their maturity date. Also known as a prompt payment discount or early settlement discount, it’s typically calculated as a percentage of the goods and…
What is inventory management? Inventory management is a systematic approach to sourcing, storing, and selling inventory. Effective inventory management involves optimizing the flow of goods within an organization, from purchase right through to sale, always ensuring that an appropriate quantity is available in the right place and at the right time to meet customer demand. Inventory in…
What is invoice processing? Invoice processing is a business function that involves managing incoming invoices from initial receipt through to payment. It’s carried out by the accounts payable department and is a critical component of the procure-to-pay process as the final step of any procurement activity. The invoice processing cycle is made up of several composite…
What is inventory cycle time? Inventory cycle time is the amount of time it takes to produce and deliver an order from a customer, usually measured in days. It essentially measures the speed at which a company can complete the manufacturing or assembly process from start to end, turning raw materials or components into a…
What is procure-to-pay? (P2P) Procure-to-pay is a term that encompasses the processes which take place when a company purchases, receives and pays for goods and services. The activities that make up the procure-to-pay process range from identifying the initial need for procurement of goods or services to the final steps of approving invoices and paying…
What is the procurement life cycle? The procurement cycle is the process businesses use to find and obtain goods. It involves multiple steps, including identifying the need for a good or service, finding the right supplier, negotiating terms, creating a purchase order, and receiving the delivery. It’s also known as the procurement life cycle or,…
What is receivables finance? Receivables finance, or receivables financing, is a trade finance method businesses can use to receive funding matching the amounts owed to it by its customers in outstanding invoices. These amounts are known as trade receivables or accounts receivable. By financing its receivables, a business can receive payments earlier, meaning it can…
What is reverse factoring? Reverse factoring is a type of supplier finance solution that companies can use to offer early payments to their suppliers based on approved invoices. Suppliers participating in a reverse factoring program can request early payment on invoices from the bank or other finance provider, with the buyer sending payment to the…
What is trade finance? Trade finance is the term used to describe the tools, techniques, and instruments that facilitate trade and protect both buyers and sellers from trade-related risks. The purpose of trade finance is to make it easier for businesses to transact with each other. It also helps to reduce the risks involved in…
What are trade receivables? Trade receivables are defined as the amount owed to a business by its customers following the sale of products or services on credit. Also known as accounts receivable, trade receivables are classified as current assets on the balance sheet. Most companies allow their customers to use credit on purchases of goods…
What is strategic procurement? Strategic procurement, or procurement strategy, is the process businesses use to acquire goods or services of the right quality, at the right price, and in time to meet customer demand. It brings procurement activities in-line with a company’s broader objectives, while also reducing supply chain risk. Strategic procurement is a long-term, organization-wide…
What is supply chain finance? Supply chain finance, also known as supplier finance or reverse factoring, is a financing solution in which suppliers can receive early payment on their invoices. Supply chain finance reduces the risk of supply chain disruption and enables both buyers and suppliers to optimize their working capital. Unlike other receivables finance…
What is vendor management? Vendor management is a term that describes the processes organizations use to manage their suppliers, who are also known as vendors. Vendor management includes activities such as selecting vendors, negotiating contracts, controlling costs, reducing vendor-related risks and ensuring service delivery. The vendors used by a company will vary considerably depending on…
What is working capital management? Working capital management is a business process that helps companies make effective use of their current assets and optimize cash flow. It’s oriented around ensuring short-term financial obligations and expenses can be met, while also contributing towards longer-term business objectives. The goal of working capital management is to maximize operational…