Why Should SMEs Consider Trade Financing Over Legacy Banks?

Why Should SMEs Consider Trade Financing Over Legacy Banks?

Businesses need to facilitate trading, both internationally and domestically, using certain financial products and advances. Any such instruments, which aid in this trading process, can be termed as trade finance. As per a report, around 80%-90% of the trade at present rely on trade financing.

As you may have already guessed, trade financing is an umbrella term, encompassing various financial products.

While trade finance is an additional source of funding for bigger companies and corporations, they mostly represent the only viable financial option for small and medium enterprises. Still, the trade finance gap across the globe was estimated to be around $1.6 trillion in 2016. In Asia alone, this deficiency accounted for around $692 billion.

Why Do Indian SMEs Struggle To Raise The Necessary Funds?

The Indian small and medium enterprises are responsible for providing a significant number of jobs to the unskilled and semi-skilled workforce in the country. This sector is also a major contributor to the nation’s Gross Domestic Product. Still, small businesses often struggle the most, when it comes to securing business finance.

The following are some of the primary reasons behind it – 

  • Limited Loan Principals

Such small companies do not borrow at the same scale as those of the mega-corporations or MNCs. Due to their limited scope of operations, their financing needs are extremely limited when compared to these larger businesses. Banks are reluctant to lend such an insignificant amount to SMEs since the risk involved is much higher than the profits.

  • Absence Of Collateral

If you are a small business owner, you will know that such companies rarely have any valuable assets, which they can leverage against a loan. Without such security, the chances of acquiring trade financing for SMEs is lowered further. No legacy banks are interested in lending an amount to these companies, without collaterals to offset the added risk.

  • Poor Revenue Generation

The scale at which an Indian small or medium business operates is vastly different from that of other countries. In most cases, SME companies fail to make sizable profits, which lower a bank’s confidence in them as borrowers. With such minimal income, a small business may struggle to repay trade financing that it avails from a lending institution.

Understanding How Trade Financing Works

Trade finance in India works in the following manner – 

  • The exporter arranges for trade finance with a lending institution and informs the same to an importer.
  • The goods or products are exported to their buyer. At this time, this exporting company receives up to 90% of the trade price from its financing company.
  • The buyer of such products, on the other hand, can choose to avail this credit for one month, two months, three months or four months. During this extended period, the buyer can sell these goods and recover his/her revenue. 
  • After this credit period ends, the buyer can repay the financing company its dues. Once the financier’s balances are settled, an importer would pay the remaining sum to the exporter.

For instance, if you receive 90% of the invoice value from a lending institution, you will receive the remaining 10% directly from the concerned buyer, but a few months after the initial payment.

How Is Trade Finance Useful For Businesses?

Trade financing nullifies the risk faced by exporters and importers during international trade. During a trade, the exporter wants to receive payment for goods upfront to prevent losses or hassle due to non-payment. Similarly, an importer hesitates to pay first before receiving its goods, as doing so may lead to the other company not honouring their deal.

Trade financing solutions balance this risk between exporters and importers equally. In this instance, an exporter receives a majority of its due payment upfront, while an importer receives a credit period when it can test and sell the received goods.

You can clearly make out the similarities between trade finance and invoice factoring. In this latter option, businesses can avail funding against their unpaid invoices. The invoices in question are effectively sold to lending institutions that are free to collect the payment from a concerned customer. Business owners, in this regard, can also opt for invoice discounting as a viable financing option, wherein the involvement of customers is done away with. 

Bottom Line

SMEs can use a reliable source of funding, such as trade finance to continue their operations. Although it does not function as a regular credit, trade finance can enable such small-scale enterprises to trade internationally, without facing excessive risks. At a time when funding from typical banks is not an option, these small and medium organisations can rely on trade financing institutions for help with liquidity once a deal is finalised.