What’s Better: Letters of Credit, Line of Credit, or Trade Financing For Your Global Business?
In UNCTAD’s Global Trade Update report of November 2021, the value of worldwide imports and exports reached USD $ 5.6 trillion in the third quarter of 2021. International trade in 2021 is bouncing back from the slumps recorded during the Covid-19 pandemic. This positive trend is due to demand picking up after the easing of Covid restrictions, economic stimulus packages, and higher commodity prices. This is encouraging news for global business owners.
This article at a glance:
As their businesses grow and expand, merchants might require letters of credit, line of credit, or other trade financing options to mitigate the risks of doing business internationally. What are these and what do they mean for a global business?
Letters of Credit
What is a letter of credit?
In international trade, there is a buyer and a seller, i.e. an exporter. A letter of credit is a conditional guarantee issued by the buyer’s bank to pay the seller’s bank a fixed sum of money within an agreed timeframe. The letter of credit is in place in case the buyer is unable to pay for his purchase, the bank would pay all or part of the amount of purchase. In return for providing the guarantee, banks demand a pledge of securities or cash as collateral and usually charge a percentage of the size of credit as a service fee.
What are the different types of letters of credit?
The most secure letter of credit is one that is “confirmed and irrevocable”. A “confirmed” letter of credit is where there is confirmation or additional undertaking from a second bank, or a confirming bank, to settle payments when the documents following the terms and conditions of the credit are presented. An “irrevocable” letter of credit is one that could not be changed or canceled unless every party agrees. Other common types of letters of credit include: revocable, unconfirmed, and transferable (the beneficiaries could be transferred; usually if intermediaries are involved).
What are the pros and cons of letters of credit?
These are the pros and cons associated with letters of credit:
Pros:
- Provides security to both buyer and seller;
- Minimizes risk of expanding business internationally;
- The risk of non-payment is transferred from the seller to the banks.
Cons:
- Banks charge fees for issuing letters of credit;
- Strict terms to be met and documentary proofs are to be provided;
- Subject to expiration date; the exporter might be rushed to deliver the goods on time.
When are letters of credit used?
Letters of credit are important in international trade due to the risks involved in global trades: different laws governing different jurisdictions, the distance between the buyer and seller, and the mutual lack of trust between them. Buyers are reluctant to pay upfront for goods fearing non-receipt while sellers are hesitant to send out unpaid goods. A letter of credit would most usually be used in this situation to guarantee payment to the seller.
Banks or credit insurers themselves sometimes require exporters to get letters of credit. Letters of credit are also used when you are not sure of the creditworthiness of your new customer, or when the country you are trading with is not politically stable or not known as a reputable international trading partner.
Line of Credit
What is a line of credit?
A line of credit in business is a hybrid between a standard loan and a credit card. A business can withdraw funds within a set amount, e.g. $ 50,000, and interest is charged as soon as the money is withdrawn or borrowed. However, the interest rate is variable and depends on when the money is drawn. The business can repay the line of credit immediately or over a pre-agreed period of time.
What are the different types of lines of credit?
Open-end or revolving lines of credits give users access to funds without having to reapply for a second time. A closed-end line of credit is similar to an installment loan where you need to repay both principal and interest in regular payments within a fixed amount of time. Other types of lines of credit include secured (with collateral) lines of credit and unsecured (without collateral).
What are the pros and cons of lines of credit?
These are the pros and cons associated with lines of credit:
Pros:
- Convenient regular borrowing by parties currently trading with each other;
- Payment received by exporter when products are shipped or services rendered;
- Buyer has flexibility in repayments —whether in lump sums or over several years' time.
Cons:
- High-interest rates which accumulate as soon as money is borrowed or withdrawn;
- Difficult to obtain or be approved by banks;
- Monthly or annual maintenance fees might be charged (depending on banks) if the line of credit is not used.
When is a line of credit used?
A line of credit might be used for businesses that are seasonal in nature, where it could help cover payroll and overheads during the off-season. It could also be used for short-term needs when the cash flow is tight, such as covering costs while awaiting payments for clients, stocking up on inventory with bulk purchases, or repairing equipment. Be wary though because its interest rate is higher than term loans, even though the line of credit might seem useful when your borrowing needs are not predictable. Repayment-wise, lines of credit are more flexible than term loans because generally, you would not be penalized when paying in lump sums.
Trade Financing
What is trade financing?
Trade financing is a general term that encompasses the financial products and instruments that banks and companies utilize to finance international trade and commerce. With trade financing, importers and exporters are able to carry out their operations globally.
Payment and supply risks are removed or lessened by trade finance through introducing third parties in transactions: exporters are assured with receivables or payments while importers would be granted credit to carry out successful trading.
What are the different types of trade financing?
Letters of credit and lines of credit are part of trade financing. There are many trade financing options, which include, purchase order (PO) finance, supply chain finance, working capital loans, overdrafts, factoring and forfeiting. Ultimately, trade financing seeks to mitigate trade risks through various trade financing instruments such as credit insurance, foreign exchange products, insurance, etc. These products address different risks such as political, non-payment, transport, shipping, or currency risks.
What are the pros and cons of trade financing?
These are the pros and cons associated with trade financing:
Pros:
- Reduces the risks of non-payment and non-receipt of goods;
- Boosts operations efficiency and improves cash flow;
- Increases revenue and reduces companies' financial burden.
Cons:
- Most trade financing options involve interest. Paying for interest adds to costs and impacts cash flow and profit negatively.
- Banks charge fees on top of interests for providing trade financing services;
- The loan application process could be lengthy and requires many documents, and/or collateral. Loan terms need to be negotiated too.
When is trade financing used?
Trade financing is used to help international exporters manage their business risks when trading globally. It provides guarantee and assurance to all parties and to ensure a smooth flow of transactions, and to minimize volatile exchange rates, and cash flow problems.
Exporters concerned with the interests associated with trade financing could seek Islamic trade financing alternatives, government or organizational grants, or equity financing for their global businesses. But as a global business owner, you know the needs of your company the best.
At Silverbird, we partner with international merchants like you to facilitate cross-border payments and simple, low-fee currency conversions. Get started with your online business account for a truly borderless trade experience.
