Working Capital and Risk in International Trade
In the same way that without DNA there would be no life, without supply chains there would be no trade, no commerce, no finance and no banks. Like DNA, supply chains are complex, inter-related systems. Each step in the supply chain is itself a complex system. It is this hierarchy of complexity that makes supply chains unpredictable. It means that businesses have to have reserves of physical stock and working capital to mitigate against the effect of shocks to the system through, for example, late payment of invoices, lack of stock or excessive stocks.
Supply chains comprise three parts: the physical movement of goods and services from suppliers to buyers and the movement of information and cash between them. The latter are often referred to as the financial supply chain.
It is impossible to divorce supply chains from working capital. Working capital is the money available to a business to carry out its day-to-day operations. Effective working capital management is critical for the continuing success of any business. As a minimum, a company’s working capital needs to generate sufficient funds to pay its liabilities as they fall due. These may be more than just the cost of stock and raw materials and may include interest, bank charges and taxes.
Organisations purchase goods, sell them on and get paid for them. Inefficiencies in the physical supply chain and the financial flows along it lead to an increased requirement for working capital. Traditionally, this has been financed all or in part with a bank overdraft. So, the cost to a company of managing its working capital inefficiently is generally high interest charges.
In many cases, a company’s working capital requirement is substantially higher than it needs to be. This is because the company is faced by uncertainty and risks and has to keep liquid funds available ‘just in case’. These uncertainties and risks are frequently the result of lack of timely, or insufficiently detailed, management information; delays in collecting payments and uncoordinated manual processes. For example, a company will need to keep sufficient cash available – or borrow it from a bank – to pay the monthly wage bill if it can’t be sure when its invoices are going to be paid. So, the efficient use of working capital is driven by supply chain efficiency.
The main issue facing exporters is probably “Can I be certain that I will get paid, as agreed, for the goods I supply?” The importer will be asking “Can I be certain that the goods I order will arrive on time and be exactly to the specification agreed?”
But these are not the only risks for international traders. There are currency exchange risks. An exporter will want to receive payment in the currency of its choice, which may or may not be the currency of its domicile, whereas an importer will want to pay in a currency of its choice, often its own. Each will ask, “can the currencies be traded with one another?”
Additionally, there are different languages, laws, regulations and taxes to be considered, as well as methods of transport, insurance and when payment is taken.
In international trade, the principal methods of settlement are open account, documentary collections, documentary credits (letters of credit) and advance payments. The risks to the exporter and importer will vary from one method of payment to another. The riskiest for the exporter is open account and for the importer, advance payment. Payment methods vary from region to region. For example, it is normal for companies to trade on open account terms within Europe, but to use letters of credit when trading with Asia.
Banks can be considered to be in the business of selling risk. The riskier a deal, the more expensive it is in terms of fees, premiums and interest rates. The more companies can do to reduce the risks, the cheaper it is for them to trade. A low risk, efficient supply chain is the solution companies should aim for to minimise their working capital requirements.
Over the years, banks have developed a range of products to help their customers reduce the risks of trading internationally. Let us consider them briefly.
Sometimes exporters – especially those trading on open account – may be able to obtain credit insurance to protect themselves against the commercial risk of the importer or the country not paying. Although credit insurance usually only pays out up to 90% of the invoice value, it is much less time consuming and costly than a letter of credit. However, the credit insurer will not always insure without a letter of credit and may not insure at all.
Documentary collections are more secure than open account trading, but less than a letter of credit. They can provide a viable and cheaper alternative to using a letter of credit. Documents, along with a bill of exchange, are sent through the banking system.
The importer is offered the documents by the bank in exchange for payment or acceptance of the bill of exchange (if payment is due at a later date). In this system there is no guarantee of payment from the bank, and the importer may refuse to take up the documents, but the exporter still retains some amount of control over the goods by sending the documents through the banking system.
A letter of credit is defined as “an undertaking by an issuing bank (the importer’s) to the beneficiary (the exporter) to make payment within a specified time, against the presentation of documents which comply strictly with the terms of the credit.”
The exporter’s risk of non-payment is transferred from the importer to its bank providing the exporter presents the documents in strict compliance with the credit. If the exporter’s bank ‘confirms’ the letter of credit as well, it promises payment, assuming the issuing bank and country risk. It is important to remember that all parties in the letter of credit transaction deal with documents, not goods, and it is important to make sure that the goods are independently inspected and verified.
Other than payment in advance, a letter of credit is the most secure method of payment in international trade. The bank undertakes to make the payment as long as the terms of the credit are met. The letter of credit also provides security for the importer, which can ensure all contractual documentary requirements (such as the quality and specification of the goods) are met by making them conditions of the letter of credit.
Pre-shipment finance is provided to the exporter to enable it to purchase and pay for goods for either direct re-sale or inclusion in manufactured goods, before receiving payment from the importer. Post-shipment finance is provided to the exporter from the time the shipping documents are available when the goods have been shipped, until payment is received. Typically a bank would advance a proportion of a letter of credit issued in the exporter’s favour. Once the letter of credit is settled, the bank loan is repaid.
There are two types of import finance. In an import loan with goods control, the bank creates a loan account to pay for the documents and the goods are placed in a warehouse under its control. The importer repays the loan and releases the goods. However, many importers need access to the goods immediately and in these instances the goods are released ‘in trust’. To ensure payment, the bank will usually issue a loan matching the importer’s trade cycle.
These are two forms of receivables financing. The bank will give the exporter a percentage (usually 80%) of the value of the invoice immediately and pay the balance, less its fees and interest, when the invoice is paid. In factoring, the bank will manage the exporter’s sales ledger and collect payment from the importers.
Supplier finance enables major importers to benefit from extended supplier credit terms or early settlement discounts, while at the same time offering their suppliers immediate cash for approved invoices.
Suppliers can choose to turn invoices into cash at any time and select just the invoices they want funded, thereby matching exactly their working capital requirement day by day and always with the certainty of receiving funds from a bank when they need it, as opposed to ‘hoping the customer will pay on time’.
The foreign currency aspects of importing and exporting can affect the ultimate profitability of the transaction. Banks offer products to facilitate transactions and manage the inherent risks – spot and forward exchange contracts, currency options and swaps, etc.
Importing and exporting is a risky business. Banks have developed a range of trade finance products to help companies minimise these risks, allowing them to trade securely, have certainty of their cash flows and reduce the amount of working capital employed.