Terms of Trade (Short-term)

International Finance/Short-term Financing
By MSU Global, WikiEducator is licensed under CC BY-SA

Short-term Financing

Module Introduction

This area of financing provides many options for an exporter and in some cases desirable financing options for an importer. It is important to remember that all options carry risk and the greater the risk the higher the cost. When evaluating risk, the associated costs must be a factor in the cost equation. The financing tools that have been presented in other sections merge at this point into potential financing options. These options include financing from vendors (suppliers), banks, insurance (making receivables eligible for financing), standby letters of credit (to provide credit terms from a seller), commercial letters of credit (under acceptance financing), government programs (pre- and post-shipment financing options) and documentary collections (under extended payment terms with an accepted draft). These options are tied to inventory and accounts receivable which are short- term in nature and turn over within a six- month period, or in some cases up to one year. Careful examination of these options is necessary to select the right option for the right price and risk level. This module will introduce you to the forms and functions of short-term financing: credit insurance, government-supported finance, discounting, time-draft letters of credit, and the Export Working Capital Program.
If you are not familiar with the basic accounting terminology covered in this module (accounts receivable, debit, credit) you need to review a basic accounting book to familiarize yourself with the terms. You will find reference to letters of credit and a variety of other payment terms covered in detail in Module 4: Payment Methods.

Identify and arrange short-term (up to 180 days) pre- and/or post-shipment finance for a seller to ensure lowest cost financing at acceptable levels of risk.

About this Resource

These resources were developed by MSU Global with funding provided by a U.S. Department of Education, Business in International Education [3] Title VIB grant.
• MSU Global International Business Resources Project

Forms of Short-term Financing

Short-term financing opportunities are available in a variety of ways to firms in global business. The majority of short-term transactions covered by financing are for periods of 180 days or less. Short-term financing requirements result from the need to increase inventory. Inventory is then converted to sales which, if extended payment terms are given, create accounts receivable. Inventory and accounts receivable are short-term in nature and provide a collateral base for a lender to provide financing. A company may need financing when the inventory and accounts receivable grow at a fast pace as a result of continually increasing sales. Then there is a greater need for funds to support the increase in the accounts that are growing at a faster rate than the accounts receivables can be converted to cash. The key factors in determining eligibility for short-term financing are whether the product is to be re-sold or used by the buyer. Financing is limited by the product’s useful life and whether or not it is considered capital equipment or inventory. Capital equipment can usually be financed for periods greater than one year, whereas most manufactured goods and agricultural products cannot. There are always exceptions to this rule; for example, many governments promote the export of agricultural products by offering guarantees on medium-term financing. In the US, such guarantees are offered by the Commodity Credit Corporation.

• identify short-term (180 days or less) financing opportunities (government and private).
• identify how credit insurance is used as a form of short-term financing. identify the difference between loans and guarantees.

The goal of this material is to introduce you to the forms of short- term financing available to support international business transactions. This lesson includes an introduction to the various costs and risks of each form of financing. By the end of this unit you will be able to

Unit Outline

• Introduction
• Preparing to Borrow Needed Funds
• Vendor Financing-Payment Terms
• Documentary Collections
• Bank Check
• Personal Resources
• Bank Financing
• Export Credit Insurance
• Other Guarantees Linked with an Export Product
• Ex-Im Bank Financing (Export-Import Bank of the US)
• Small Business Administration (SBA) of the US
• Equity Investment
• Earnings Requirments
• Working Capital
• Collateral
• Resource Management

• Primary Difference Between Ex-Im Bank and the SBA
• Factoring
• Forfaiting
• Summary
• Resources
• Activities
• Assessment

Resources

Correlation: Materials from this unit correlate with NASBITE CGCP [2]’s Knowledge Statement 04/07/01: Knowledge of forms and functions of short-term financing (e.g., credit insurance, government supported finance, discounting, time draft letter of credit, Exporting Working Capital Program.

Preparing to Borrow Needed Funds

Financial statements must be available for internal and external purposes. The financial statements represent the company and tell the story of its history to others. Companies with good financial statements have a better chance of getting credit from all available sources. The better the financial statements are, the lower the credit risk is, creating more favorable financing options for a buyer. To qualify for any financing option, a buyer will need to meet the requirements of the funding provider. The company’s financial plan determines what options will be available. Thus understanding and properly preparing a good financial plan is primary. It is not essential to understand a balance sheet in its entirety, but it does help to have an understanding of the relationships between some of the items listed on the balance sheet and income statement since lenders look very carefully at these relationships. The key matter is the relationship of the accounts receivable to sales and the transition to cash:

• Accounts receivable are a desirable asset. Banks and factors scrutinize these because accounts receivable provide collateral for the basis of a loan.
• Sales are the outcome of extending payment terms which then create accounts receivable.
• Inventory is decreased, and cost of sales is increased.
• Cash is generated when a buyer pays the obligation (accounts receivable).
• Sales are the primary goal, and profits are the desired end results.
The end result of the difference between sales and cost of sales is loss/ profit that flows into the company (debit if loss, credit if profit).

Vendor Financing – Payment Terms

Open Account

Vendors are the suppliers of raw materials that are used in the production of inventory. It is in the best interest of these vendors to sell as much of their product as possible but only to a qualified buyer. Credit terms provided to a buyer are a key financing option. Most companies do not understand how important it is to have these credit terms available. The vendor or supplier of these materials or manufactured goods is actually financing the company, eliminating the need to go to another financing source to provide funds to purchase these goods. The company that meets its obligations is more likely to be able to obtain additional credit and favorable terms in the future. It is also much easier for a startup company to build a relationship with favorable terms with a supplier or vendor over any other funding source. Each will have specific qualifying criteria, but often a minimum credit facility will be provided to a buyer with a decent balance sheet.

Documentary Collections

Documentary collections allow a buyer to import goods at the risk of the seller. Buyers often pay for the documents when the arrival notice is received. The buyer having paid for the documents, the bank will release the negotiable documents to this buyer, thus allowing for the release of the goods by the carrier. Documentary collections can also be presented with an extended payment bank draft. This form of financing assigns greater risk to the seller because once the buyer accepts responsibility to pay at maturity by signing the bankdraft, the documents are released to the buyer. The title to the goods passes to the buyer, and the only recourse to the seller if the buyer does not pay at maturity is to seek legal recourse. Doing so is costly and time-consuming for the seller. The buyer could provide the seller with a guarantee of payment from his bank by transferring the responsibility for the payment from the buyer to his bank. This action occurs if the buyer’s bank, relying on the credit facility they have with the buyer, avalizes the draft, thereby assuming responsibility for the payment at maturity. It is important for the seller to analyze a buyer carefully before extending credit terms under a documentary collection.

Bank Check

Payment by check by an overseas buyer provides higher risk for a seller. Checks drawn on foreign banks do not clear through the Federal Reserve Bank. These items must be presented directly to the paying bank and can take up to eight weeks or longer to clear (clearing of checks is different in every country throughout the world). The general desired form of payment should be by wire transfer into the seller’s account at the designated bank. The second form is to accept a check drawn on a United States bank in US dollars, which allows you to collect your US dollars through the Federal Reserve Bank under laws of the United States clearing laws. Checks drawn on foreign banks require collection procedures through the banks and can easily be returned for insufficient funds or stop payment. The collection of a foreign check also takes so much time that the seller will have difficulty in applying other collection procedures against a buyer in a foreign country.

Personal Resources

Startup companies have difficulty raising money until some performance history is created. Prior to the establishment of solid financial data, a startup is dependent upon the personal resources of the owner or investors in the company. Private investors expect to have a return on their investment and the ability to sell that investment at a future date. The owners raising capital from private investors give up a portion of their business in the form of an equity interest to the investor, which dilutes the holdings of the existing owner(s) of the company. Banks always expect owners and investors to step in with additional funding first before increasing credit lines in emergency situations.

Bank Financing

Letters of Credit

Letters of credit are often used to finance purchases in a foreign transaction. Letters of credit are the guarantee of payment by the buyer’s bank (not the buyer) to pay provided the terms of the letter of credit are strictly met. Letters of credit can provide extended payment terms and still provide a guarantee of payment by the buyer’s bank, by accepting to pay the draft at maturity. This action is the source of a banker’s acceptance, which draws its name from the accepted draft. A banker’s acceptance is a method of financing that banks can use to provide customers with short-term (six months or shorter) financing for trade transactions. A banker’s acceptance is a time draft drawn on and accepted by a bank. The bank indicates its commitment to pay the stated amount of the draft on a specified future date by signing the draft on its face and thereby accepting it. The draft may then be sold to an investor for a money-market rate of return based on the credit risk of the bank. Acceptances may be less expensive than more traditional trade financing methods.

Banker’s Acceptances

Acceptance financing has been used for decades as a form of bank loan. The ability to fix rates for periods of up to 180 days protects a borrower from adverse movements in interest rates up to six months. Banks offer banker’s acceptances in a wide range of maturities to match customers’ sales cycles and payment terms. Traditionally, importers used banker’s acceptances to finance imports into the United States. Today acceptance financing is used to finance a wide- range of activity such as imports, exports, domestic shipments, domestic purchases, and commodity warehousing of readily marketable products.

Discounting

Banker’s acceptances provide a deferred payment option for a buyer but little benefit for a seller. Banker’s acceptances can be discounted to the seller freeing up funds to the seller and providing an additional income opportunity for the discounting bank. The fees and charges for discounting banker’s acceptances can be paid for by either the buyer or the seller. The accepted draft is discounted to the seller who receives a discounted amount from the bank discounting the draft. If the buyer agrees to pay for the discount fees and charges, the seller will receive the full amount of the draft, which is the reason it is important to establish who is responsible for these fees and charges in the negotiation process prior to fixing the product price. It is important to note that discounting can be done by either the buyer’s or the seller’s bank. It is possible that neither will be interested in discounting the draft, but in most cases both are available and should be confirmed before the transaction is finalized between the buyer and the seller. Whether the buyer, the seller, or their banks furnish the financing under letters of credit depends on a number of factors:

• relative negotiating position of the buyer and the seller
• availability of financing in the buyer’s and seller’s countries
• relative interest rates in the buyer’s and seller’s countries
• relative need of the buyer and seller for financing

Standby Letter of Credit

Standby letters of credit are instruments that stand by to pay if there is non-performance by a party in the transaction. Commercial sellers will accept a standby letter of credit to extend credit and to guarantee payment if the buyer does not pay. It is paid for by the buyer and issued by the buyer’s bank against the credit facility the buyer has with his or her bank. It provides the seller with the comfort of collecting against the standby letter of credit should the buyer not pay according to agreed upon payment terms. The seller should never extend more credit in the form of shipments to the buyer than the amount of the standby letter of credit because the seller is only protected up to the amount of the standby letter of credit.

Transferable Letter of Credit

Transferable letters of credit can be a very valuable financing option but are often misunderstood and improperly executed. The first task is to identify the parties in the transaction. There is an ultimate buyer and an ultimate seller, and between them in the transaction is a broker/sales representative. The broker can represent himself in the transaction or be a distributor for a much larger, well- known company. Using a transferable letter of credit, the broker requires no credit facility or collateral for his role in the transaction, making this action very valuable for the broker.

The process works in the following way: A buyer issues a transferable letter of credit to the broker; then the broker transfers to the ultimate seller of the goods the cost of the goods to be shipped. The seller now has the responsibility to make the complete shipment to the ultimate buyer. The broker will never take title to the goods; it passes directly to the ultimate buyer. The seller of the goods is happy because he/she is a party to the letter of credit and is guaranteed payment by the buyer’s bank. The buyer is happy because he/she receives the goods under strict compliance of the letter of credit (note that this transaction does not prevent fraud). The broker is required only to replace the seller’s invoice with his/her marked-up invoice (the profit) when the seller’s documents are presented to the transferring bank; these documents are in turn forwarded to the paying bank with the replaced invoice so that the broker can secure his/her profit in the transaction. This situation appears to be too good to be true. There is, however, risk. The risk is that the ultimate buyer will be able to identify the seller in the transaction and be able to eliminate the broker. This situation can be controlled by carefully structuring the documents in the preparation of the transferable letter of credit and the packaging of the product. When the broker is a distributor, however, it does not matter that the seller is disclosed.

For example, take the case of a name brand like Levi’s. A buyer knows the maker of the goods but cannot acquire them directly from the manufacturer. The broker is protected by an exclusive distribution contract with the manufacturer (Levi Strauss & Co). The benefits for the broker are now obvious: there is no financing necessary and no need for warehousing a product. The broker has the responsibility for finding a manufacturer for the buyer and preparing an invoice to correspond to the negotiated sale between the ultimate buyer and seller.
Transferable letters of credit should not be confused with a back-to-back letter of credit.

Export Credit Insurance

United States banks do not consider foreign accounts receivable to be eligible for financing, the reason being that the recourse to collect against them is limited and expensive. The United States government as well as other governments throughout the world have realized such and established guarantees to banks in the form of payment insurance to stimulate exports. Ex-Im Bank provides United States banks with a guarantee of payment for specific transactions. Some states have created similar local programs. They often work in conjunction with Ex-Im Bank to provide guarantees to lenders to stimulate their local economies. These programs allow banks to lend against a borrower’s inventory and accounts receivable, relying on the Ex-Im Bank or the state program (a domestic source to the bank) to pay in the case of default. This type of guarantee provides insurance of payment.

These programs have been recognized by independent insurance carriers as a potential revenue- generating source, enticing them to enter this market and providing competition for Ex-Im Bank. This free market competition keeps rates low for this type of credit facility and provides alternative sources for a borrower. The guarantee allows the banks to fund inventory; it is limited to Ex-Im Bank and is considered pre-shipment financing. The funding of post- shipment financing is provided by both Ex-Im Bank and private insurance carriers in the form of guarantees to a seller’s bank against accounts receivables.

The range of risk varies from one credit insurance agency to another, but here are examples of some risks covered on a standard basis:

1. Commercial risks only
a. company insolvency, including both compulsory and voluntary liquidations
b. individual insolvency (bankruptcy)
c. protracted default (slow pay)
d. receivership
e. the appointment of an administrator.

2. Commercial Risks and Political Risks
a. commercial risks including the insolvency of a customer and any default on payment (See above)
b. financial losses resulting directly from political events, economic difficulties, legislative or administrative measures occurring in a country covered for these risks which prevent or delay the transfer of the sums paid by a buyer or its guarantor (transfer risk)
c. risks of a military or a civil war, a revolution, riot or insurrection
d. general moratorium decreed by the government of a buyer’s country or by any third country covered for these risks through which payment must be made

3. Political Risks Only
a. when the client is worried only about non-commercial issues

Other Guarantees Linked with an Exported Product

The export insurer provides other types of insurance:

• A global insurance for corporations having subsidiaries abroad. For companies trading internationally, there is a growing trend for overseas sales to be made not from the head office but through a local subsidiary. The export credit insurer may offer a comprehensive and flexible credit risk management service by providing, through their international network, a cover concerning the local sales of the subsidiaries as well as the head office exports sales.
• Manufacturing risk guarantee or work in progress. The insurer can provide a guarantee concerning the goods when they are at the stage of being manufactured. This guarantee protects the exporter against the risk of bankruptcy of the importer or against political/economic risk during the time of manufacturing (before completion and the sale).
• Bid bonds or performance bonds or advance payments, or retention bonds or guarantees. These guarantee to protect the exporter against any unfair first demand call on those bonds.
• Goods exposed in foreign political upheaval are guaranteed against the political or catastrophic risk for a maximum of six months.
• Goods in a consignment stock could be insured for a period of 12 months.
• Export insurance could be extended as well to the exporter abroad on his behalf. The guarantee is applicable on the final buyer risk.
• Protection of the investment abroad. A corporation can insure its new production unit in a foreign country against the political cause of loss: expropriation, war, non-transfer.
• Other coverage, such as, supplier default, breach of contracts, trade fair insurance, etc.

Ex-Im Bank Financing (Export-Import Bank of the US)

Ex-Im Bank programs follow certain policies designed to create US jobs and adhere to US trade policies and regulations. In addition, Ex-Im Bank programs cover a variety of needs, including pre-export and post-export assistance. They also offer short, medium and long-term guarantee insurance and direct loan programs.

Because of its policy constraints, Ex-Im Bank has certain restrictions on utilizing its programs that may prevent some companies from getting support. To insure the creation of jobs in the US, all products must be shipped overseas from the US and support may be limited by the US content of the products. The final manufacturing stage must be in the US and some programs require shipment on US vessels, with few exceptions. No product can be shipped to a military buyer. Aside from these restrictions, however, support is still available for a variety of trade transactions under numerous programs within Ex-Im Bank.

Ex-Im Bank’s programs cover a variety of needs, including pre-export assistance, which is offered through pre-shipment insurance and a working capital loan guarantee program. Post-shipment assistance is provided through short, medium, and long-term programs. All Ex-Im Bank’s short-term export programs are insurance programs. These include programs to protect sales to an individual buyer (single-buyer insurance) or many buyers at the same time (multi-buyer insurance), including programs designed specifically for small businesses (the small business program and the environmental program). All goods covered under these programs must have at least 50% US content.

Working Capital Guarantee Program (WCGP)

This program gives US exporters access to working capital loans from commercial financial institutions by providing 90 percent repayment guarantees to lenders on short-term loans secured by inventory and foreign receivables. Ex-Im Bank allows exporters to obtain the necessary working capital to purchase inventory, build products, arrange bid and performance bonds, and extend terms to overseas buyers. This program provides the means for small and medium-sized companies to pursue exports more aggressively. A working capital guarantee can be issued for a specific transaction or a series of transactions in the form of a line of credit.

Delegated Authority Program

This program was created to accelerate the process of obtaining a working capital guarantee. Applicants can directly interact with commercial lenders who are extended this privilege without having to approach Ex-Im Bank. There are five levels of Delegated Authority Lenders, each with specific loan limits per exporter. The lowest lender level is limited to making loans of $1 million per exporter, while the highest is able to make loans of up to $10 million per exporter and an aggregate of $150 million. The program permits the lenders to commit Ex-Im Bank to a loan with minimal documentation and provides for the lender to split the guarantee fees with Ex-Im Bank.

Priority Lender Program

Under the Priority Lender Program, a qualified bank is assured faster turnaround for loans of up to $5 million. Qualification for this status requires completion of Ex-Im Bank training programs, completion of at least two working capital loans, and submission of a report every year. This Ex-Im Bank program guarantees its priority lenders that it will make a decision on a pending loan within 10 business days for standard transactions.
Ex-Im Bank offers short-term insurance to cover risks incurred during the pre-shipment (during the assembly or manufacturing) period for export transactions. This period is normally limited to 180 days but can be extended depending on certain factors. This type of insurance covers the exporter against the possibility of a buyer canceling his/her purchase agreement or a foreign government canceling the buyer’s import license.

Small Business Administration (SBA) of the US

The SBA has some services specifically designed to help the small business get started in exporting. SBA provides financial assistance programs for US exporters. Applicants must qualify under the SBA’s size standards and meet other eligibility criteria. The SBA has two main programs to assist US exporters– the Export Working Capital Program and the International Trade Loan (ITL) program. It is important to note that the SBA does not provide loans but rather loan guarantees.

The SBA programs provide a small business owner with financing aids that will enable the business to obtain the capital needed to get into exporting. This program is designed to help small business exporters obtain financing by reducing risks to lenders. The SBA will guarantee up to 90% of a loan from a private bank. The proceeds from the loan can be used for pre-shipment working capital, post-shipment exposure coverage, or a combination of both.

Credit managers should understand the basic credit attributes that are part of the SBA package that is funded through a bank and be able to determine if a company can qualify for SBA’s financial assistance. The company must understand basic credit factors that apply to all loan requests. Every application needs positive credit merits to be approved. These are the same credit factors a lender will review and analyze before deciding whether to internally approve a loan application, seek a guaranty from SBA to support their loan, or decline the application all together.

Equity Investment

Business loan applicants must have a reasonable amount invested in their business to ensure that, when combined with borrowed funds, the business can operate on a sound basis. There will be a careful examination of the debt-to-worth ratio of the applicant to understand how much money the lender is being asked to lend (debt) in relation to how much the owner(s) have invested (worth). Owners invest either assets that are applicable to the operation of the business and/or cash which can be used to acquire such assets. The value of invested assets should be substantiated by invoices or appraisals for startup businesses or current financial statements for existing businesses.

References

[1] http://www.bizplancorner.com/
[2] http://www.bizplancorner.com/articles/22/business-plan-writers.aspx
[3] http://www.bizplancorner.com/articles/1/business_plan_writing_service.aspx
[4] http://www.bizplancorner.com/articles/24/business-plan-service.aspx

Earnings Requirements

Financial obligations are paid with cash, not profits. When cash outflow exceeds cash inflow for an extended period of time, a business cannot continue to operate. As a result, cash management is extremely important. A company must be able to meet all its debt payments, not just its loan payments as they come due. Applicants are generally required to provide a report on when their income will become cash and when their expenses must be paid. This report is usually in the form of a cash flow projection, broken down on a monthly basis, covering the first annual period after the loan is received.

Working Capital

Working capital is defined as the excess of current assets over current liabilities. Current assets are the most liquid and most easily convertible to cash of all assets. Current liabilities are obligations due within one year; therefore, working capital measures what is available to pay a company’s current debts. It also represents the cushion or margin of protection a company can give their short-term creditors. Working capital is essential for a company to meet its continuous operational needs. Its adequacy influences the firm’s ability to meet its trade and short-term debt obligations as well as to remain financially viable.

Collateral

To the extent that worthwhile assets are available, adequate collateral is required as security on all bank loans; however, banks will generally not decline a loan where inadequacy of collateral is the only unfavorable factor. Collateral can consist of both assets which are usable in the business and personal assets which remain outside the business. Borrowers can assume that all assets financed with borrowed funds will collateralize the loan. Depending upon how much equity was contributed towards the acquisition of these assets, the lender also is likely to require other business assets as collateral. Although banks may require all, SBA loans definitely require personal guarantees by the owner or other individuals who hold key management positions.

Resource Management

The ability of company officers to manage the resources of the business, sometimes referred to as character, is a prime consideration when determining whether or not a loan will be made. Managerial capacity is an important factor involving education, experience and motivation. A proven positive ability to manage resources is also a large consideration.

Primary Difference Between Ex-Im Bank and the SBA

The Ex-Im Bank program offers exporters more flexibility and a desire to see that businesses in the US create jobs and increase exports. They also offer short, medium, and long-term guarantee insurance and direct loan programs. The SBA generally works with small businesses, while Ex-Im Bank involves itself with Fortune 500 companies and larger.
The SBA defines a small business as one that is independently-owned and operated and not dominant in its field. A small business must also meet the employment or sales standards developed by the Small Business Administration based on the North American Industry Classification System (NAICS).

Factoring

Accounts receivable are the basis for factoring. Factoring is the discounting to the holders of accounts receivables by providing financing in the form of cash to them by a factor. Factors are organizations that specialize in the financing of specific industries that are known to them. They thus have collecting clout against buyers who are responsible for paying the account receivable(s).

Factoring occurs in two forms-with recourse and without recourse. The difference lies in who takes responsibility if the buyer (debtor) does not pay. When a with recourse option is exercised, issuer of the invoice is forced to pay the factor if the debtor who is responsible for paying the account receivable (invoice) but does not pay the factor. Foreign credit insurance is often used as added protection for the issuer of the invoice. Without recourse means that the factor buys the account receivable (invoice) outright and takes full responsibility for its collection without being able to go back to the issuer of the invoice for reimbursement. Factoring is mainly used for small transactions that are available for short- term financing on a continuous basis.

Forfaiting

Forfaiting is defined as the discounting of medium–term promissory notes or drafts issued by a foreign buyer. Banks forfait larger transactions over a longer period of time. These transactions are backed by the maturing promissory notes. Banks also prefer that the drafts or promissory notes be avalized by the issuing bank, thus providing a guarantee from the avalizing bank. The benefit to the importer is the receipt of a discounted cash payment for the sale with the bank assuming responsibility for the collection of the promissory notes or drafts. Forfaiting is mainly used to finance equipment and relates to specific transactions.

Summary

A variety of short-term financing tools are available to exporters and importers. These tools range in simplicity, cost, requirements and risk. The need for financing will depend on the parties involved in the transaction, the countries involved, the products/services being traded, the amount of the transaction, and regulations that surround the transaction. Selecting and qualifying for appropriate financing tools can make or break the transaction and the profitability achieved by the importer and exporter significantly. Do your homework as programs change; identify your options; and select the appropriate tools.