Trade and Receivables Finance: A Practical Guide to Risk Evaluation and Structuring (2024)

©The Author(s)2018

Stephen A.JonesTrade and Receivables Financehttps://doi.org/10.1007/978-3-319-95735-7_1

1.Introduction

StephenA.Jones¹

(1)

AXS Trade Finance Ltd., Solihull, West Midlands, UK

StephenA.Jones

Keywords

Funding gapInternational tradeMethods of paymentReceivables financeStructured financeTrade financeTrade riskWorking capital

International trade has been a driver of growth and economic prosperity since the very beginning of commercial activity. Trade is defined as the sale of goods or services by a seller to a buyer in exchange for money, or other commercial consideration.

Cross-border trade can involve a wider and higher level of risk for the seller, buyer, and financier and increased financing requirements compared with domestic trade. It benefits however from potentially greater returns, diversification of business, and the opportunity to grow sales and revenue beyond the home market.

A key aspect of trade is the conflicting needs of the seller and the buyer. Each is concerned with different risks and payment requirements. The seller wishes to get paid straightaway, whilst the buyer wants to pay as late as possible.

It is these conflicting demands which give rise to the need for trade and receivables finance. Trade products issued or handled by banks referred to in Sect. 1.2 are used to mitigate risk for the seller and buyer. Trade and receivables financing products and solutions are used to fund the gap between settlement of goods purchased and receipt of the related sales proceeds.

1.1 Trade Risk

A company that is considering the sale of goods to an overseas end-buyer, ora buyer wishing to purchase goods from an overseas supplier, is faced with the difficult task of assessing the risks of the international transaction.

The seller is concerned that they may not be paid for goods supplied, be paid late, or their sales invoice may not be settled in full. The buyer is exposed to the risk that they may not receive the goods at all, or receive them too late, or the specification, quantity, and quality of the goods received do not conform to their purchase order. Without the benefit of an established trading track record, the seller is exposed to the risk of non-payment, and the buyer to the risk of not receiving the required goods.

It can be difficult to obtain information on an end-buyer or supplier which is based overseas. In the absence of a trading track record, or local knowledge, reliance is placed on publicly available financial statements, a report from a credit reference agency, press articles, and any internet-based information or market feedback.

Accounting standards, regulations, and market practice vary in overseas markets. This can render the type of financial information that is publicly available either virtually non-existent, unreliable, opaque, or significantly out of date. The local requirement for independent audit of statutory financial statements can also vary.

Financial information on the end-buyer may therefore be of a nature that cannot be relied upon to predict their ability to settle an invoice on the future due date for payment. Even when the credit risk assessment of the end-buyer is deemed acceptable, their country may have insufficient foreign exchange reserves in which to transfer the currency value of the invoice, even though the end-buyer has paid in local currency.

The government of the overseas end-buyer, or countries through which the goods will travel, or money may pass could introduce measures which prevent the importation of goods or the transfer of funds in settlement of the transaction.

Historic financial information and limited market feedback are unlikely to provide substantive independent validation of a supplier’s ability to perform and deliver goods of the required nature and quality on a timely basis.

A seller or buyer is therefore faced with a decision to make against an incomplete information base upon which to adequately evaluate risk.

This also exposes the trade or receivables financier who relies primarily on the receipt of sale proceeds from the transaction financed for their repayment. Any risk which impacts upon or impairs the successful conclusion of the financed trade transaction can result in non-payment, or a reduced settlement amount, thus placing in jeopardy the financier’s source of repayment.

The risk profile will vary from transaction to transaction. Factors that impact on the level of trade risk are the credit status of the end-buyer, the political and economic situation of their country, the method used to obtain payment, the length of trade credit terms, and the reputation of the supplier and their supply chain to deliver quality goods on time.

It is important therefore that the client and financier identify aspects of the trade transaction that could go wrong, assess the probability of issues arising, mitigate any unacceptable risks, and have contingent arrangements in place should problems arise.

The required level of risk mitigation can be achieved by using the right method of payment to collect or make payment according to the risk profile of the transaction, structuring this in the best way, and stipulating trade documentation which evidences contractual performance.

1.2 Methods of Payment

Global trade requires a means of making and collecting payment between commercial parties in different countries. Because of the geographical distance it is more difficult for the seller to evaluate the probability of payment default, and the buyer to assess whether they will receive the goods ordered, on time and to the required quality.

Whilst trade should not be conducted when there is an absolute absence of trust, there are a variety of trade products issued and handled by banks that provide a mechanism for the payment of transactions against the provision of trade documentation. These help to supplement limited information on the supplier or end-buyer. Trade products such as letters of credit, documentary collections, and bank aval provide the means of settlement for both domestic and international trade transactions. With each of these, trade and shipping documents are exchanged between banks in return for either payment or the receipt of an undertaking to pay. Trade products such as demand bank guarantees and standby credits give financial recompense in the event of default in payment or contractual performance.

Each of these will be explained and explored in detail throughout this book. Not only are trade products important to mitigate trading risks for the commercial parties, they can also be stipulated and structured by the financier to reduce financing risk. These products can help commercial parties to increase trade, diversify into new markets, and thereby grow business and revenue. In turn the financier that supports or funds these transactions can grow their client base and income streams.

The seller and buyer will therefore need to carefully assess the trade risks and decide upon the most appropriate method of collecting and making payment. This can be determined by the ‘risk ladder’.

The methods of payment can be split between those which involve no intervention or intermediation between banks other than making a bank transfer to the seller when instructed to do so by the end-buyer such as advance payment and open account, and others where trade and shipping documents are exchanged between banks in return for either payment or an undertaking to pay.

It can be seen from Fig. 1.1 that the safest method of payment for the seller is the riskiest for the buyer and vice versa. This reflects the conflicting needs of the commercial parties. If the seller evaluates the risk of non-payment as high, they will select a method of payment and documentation which provides control over the goods until such time that they have obtained payment or an undertaking to pay from the end-buyer’s bank.

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Fig. 1.1

Payment risk ladder

1.3 Advance Payment

The safest method for the seller is to receive payment before they have manufactured or shipped the goods. This is known as ‘advance payment’. However, this represents the highest risk for the buyer; having paid for the goods they may never be shipped. There are trade products such as standby letters of credit and demand bank guarantees which can be used by the buyer to reclaim monies paid in advance when the goods are not received, as described in Chaps. 14 and 15.

1.4 Letter of Credit

When the seller requires a bank to provide payment or their undertaking to make payment on a future determinable date against the presentation of stipulated trade-related documents, a letter of credit may be used. A letter of credit provides a secure method of payment for the seller when they can ship the goods by the specified date and present the required trade documents within the time allowed.

Not only does this provide payment risk mitigation to the seller, it allows the buyer to specify the documentary terms, conditions, and timescales which must be fulfilled by the seller. It can also be used as an effective financing mechanism for either the seller or the buyer. Letters of credit are examined in Chaps. 12 and 13.

1.5 Documentary Collection

When the value of the shipment does not warrant the cost and administration of a letter of credit, or where the seller is comfortable with the credit status of the end-buyer but is concerned about delayed payment, the seller may request their bank to arrange the exchange of shipping documents, via the bank of the end-buyer, against the fulfilment of specified conditions. The bank will usually be instructed to release shipping documents against payment or against the end-buyer’s undertaking to pay at a future fixed or determinable date. Collections are described in Chap. 10.

1.6 Bank Aval

When the seller is using a documentary collection but wants the added security that payment will be guaranteed on the future due date, they can instruct that the shipping documents may only be released to the end-buyer against the additional undertaking of the end-buyer’s bank to pay, known as a bank aval. Bank aval is covered in Chap. 11.

1.7 Open Account

Open account trade is the most common form of payment. This allows the buyer to make payment to the seller only once they have received the goods, inspected them, and found them to be fully acceptable. The buyer is therefore in full control. They will only request their bank to make a bank transfer in settlement of the transaction when they are willing to pay and have sufficient funds to settle the invoice.

This form of payment represents the highest risk to the seller. Once they have delivered the goods to the end-buyer and raised their sales invoice requesting payment, they have no certainty that the end-buyer is able or willing to pay on the due date for payment. The seller has lost control of the goods and is therefore totally exposed.

This form of payment should only be used by a seller when there is an established successful trading track record or where the seller is not concerned with the credit status of the end-buyer or their country. When the seller is forced to trade on open account terms because of competitive pressure and is concerned that they will not receive payment, credit insurance can be used to mitigate the risk of insolvency of the end-buyer. Credit insurance is explored in Chap. 21 and the financing of open account trade receivables in Chap. 23.

Alternatively, a standby credit or demand guarantee can be sought which enables the seller to claim payment from a bank when the end-buyer defaults on payment, as explored in Chaps. 14 and 15, respectively.

In summary, to provide optimal risk mitigation and finance, the correct trade product needs to be used and appropriately structured. This book will describe each of the key trade products, how they operate, when they should be used, and how to structure these to mitigate risk and facilitate financing.

1.8 Commercial Terms

The commercial terms agreed by the seller and buyer, the trade products used, and the funding solution are often poorly structured, exposing either the seller, buyer, or financier to risk. Furthermore, the terms of the underlying commercial contract or trade product can also impact upon whether the transaction can be financed, and the level of funding that can be provided.

Guidance will be made to financiers on assessing the underlying commercial trade terms. Clauses that expose the financier to risk will be highlighted and discussed in Chap. 4. These can be critical when financing open account transactions because the willingness of the end-buyer to pay the sales invoice depends on the seller’s compliance with the commercial terms and conditions.

Recommendations will also be provided on how each of the trade products can be best structured from the perspective of the financier.

1.9 Working Capital

This is the part of a company’s cash resources or borrowing which funds the operation of the business. Working capital is used to purchase raw materials and components as inputs for the manufacture of finished or semi-finished goods, or to purchase goods for stock or their onward delivery to an end-buyer. Overheads such as wages, rent, heating, lighting, and other ‘indirect’ operational costs are also funded by working capital.

Working capital is the ‘lifeblood’ of a business and no company can function and survive without it. The timing mismatch, or funding gap which arises between payment for goods and receipt of sales proceeds, known as trade receivables, often gives rise to short-term borrowing to fund this.

1.10 Funding Gap

A transactional funding gap emerges between the timing of payment to a supplier and the receipt of monies from the use or sale of the related goods. The funding gap is directly impacted by the period of trade credit allowed to end-buyers before they are required to pay, or time taken by those who do not settle the invoice when due, and the length of trade credit received from suppliers.

This gap is funded either through cash which has been generated and retained within the business, shareholders’ funds in the form of equity investment and loans, trade credit from suppliers, bank overdraft, and short-term revolving loans, or a combination of these.

1.11 Working Capital Cycle

Working capital will usually revolve around the business several times during the year as raw materials, components, or goods are purchased, possibly manufactured, processed or assembled, stored in a warehouse, sold, and proceeds received. On each turn of this cycle the business should produce a profit from the sale of goods at a higher value than their cost of production. The receipt of sales proceeds generates liquidity in the form of cash. This is known as the ‘working capital cycle’.

Cash is recirculated to pay creditors and the workforce and to start a new cycle by purchasing replacement raw materials, components, or finished goods.

The profit element is either retained to increase the cash resources of the business to provide a contingency reserve in case of future difficult trading conditions, or used to reduce debt, purchase additional stock, or invest in the development of the business.

If the end-buyers cannot pay on time, are unable to pay at all, or are not prepared to pay because of dissatisfaction with the goods, the working capital cycle revolves more slowly or breaks down and fails to revolve at all. This will result in cash flow and liquidity problems.

1.12 Working Capital Management

A business will wish to ensure that they are managing their working capital effectively by maximising the credit received from their suppliers, minimising the time that goods are held in stock, reducing the period that sales invoices are outstanding, and increasing the profitability of transactions. The effective management of these aspects will preserve cash, increase liquidity, and reduce or eliminate the funding gap. This will result in a stronger business, more resilient to economic headwinds or turbulence, with greater capacity to self-fund or to obtain external finance to grow.

1.13 Conventional Lending

Conventional lending products comprise overdrafts and revolving loans. An overdraft allows the client’s designated bank account to become overdrawn up to a permitted limit. The balance of the bank account should fluctuate in value as payments are debited to the account and proceeds are received. The overdraft limit is usually based upon the financier’s credit assessment of the client’s ability to repay and available covering security.

Conventional ‘balance sheet’ credit risk assessment is largely based upon the historic statutory financial statements of the client, such as their profit and loss, balance sheet, and cash flow statement ideally covering the previous threeyears, latest management accounts, business forecasts, and cash flow projections. These are used to assess whether the client can be relied upon to manage their business effectively and to generate sufficient sustainable cash from which they can cover their overhead costs, such as wages, gas, electricity, rental payments, and so on, pay trade creditors and interest on their debt, and repay borrowing.

Financial statements are a historic snapshot in time. They have been known to be manipulated or ‘window dressed’ at the financial year end to present the best possible picture. At best, these will be several months’ old and may not therefore be a reliable predictor of the future.

Management accounts are internally prepared, unaudited and may be inaccurate. Sales forecasts and cash flow projections are often overly optimistic. Even when produced on a prudent basis these can be blown off course by unforeseen internal and external factors.

The lender has little control over the use of the borrowed monies and limited visibility on the cash flows from which the lending will be repaid. The financier relies upon the client’s ability to use their own cash and the financier’s funds wisely, generate a sufficient level of profitable sales to creditworthy end-buyers, collect in the cash on a timely basis, manage their business effectively, pay their debts as they fall due, and retain sufficient cash to repay the financier. The primary source of repayment is therefore the client themselves.

The lender will take security over the general assets of the client as a secondary means of repayment should they not be able to repay the financier.

Often, the first sign of trouble is when the overdraft stops fluctuating from a debit to a credit balance and remains overdrawn. The amount of the overdraft which no longer fluctuates is known as ‘hard core’ debt. This can hide losses or bad debt. By the time this becomes evident, it is often too late to take remedial action other than to convert hard core debt onto a term loan with staged repayments.

1.14 Finance of International Trade

International trade often requires a greater level of finance or credit support due to the length of time a transaction can take from beginning to end. This is known as the ‘trade cycle’.

For example, the seller may require a guarantee of payment from the bank of the end-buyer, or a deposit before they are prepared to manufacture or ship the goods. Order lead times may be longer given the distance the goods will need to travel. It may be more economic for shipping containers to be full, thus increasing the number of units purchased.

Once manufactured or procured, the goods will be shipped to the end-buyer; this may take several weeks. As a minimum, the end-buyer will not wish to pay until the goods have been received. The end-buyer may then need to store the goods in a warehouse pending sale and delivery to their customers.

A lengthy lead time from order to arrival of the goods may result in a higher quantity of goods being purchased to ensure they are held in stock and available for immediate local delivery to customers. The resultant higher stock holding will take longer to sell, thus impacting negatively upon the cash resources of the buyer, requiring either an increased level of finance, much longer trade credit terms from the supplier, or both. This is particularly true for a distributor whose role is to market and sell goods which they hold in stock.

If the buyer is purchasing a machine, they may require credit terms of 1–5 years. This is to enable the use of the machine to generate cash flow from which the buyer can pay the supplier.

Unless the seller has commercial leverage due to the uniqueness of the goods, they will be faced with competitive pressure to provide trade credit terms which allow the end-buyer to pay for the goods at a future specified date.

International trade can therefore involve a much longer transactional cycle to accommodate transit time, stock holding, and trade credit terms. Each of these elements alone can place pressure on cash flow and, when combined, they can result in a cash crisis unless funded in an appropriate way across the complete trade cycle from beginning to end.

The increased requirement for finance or credit support can often go beyond the conventional financier’s appetite to lend. This is because traditional lending products are based upon and limited to the client’s ability to repay the debt.

Trade and receivables finance provides an important and viable alternative solution where the financier is repaid from the transaction which has been financed and not by the client.

We shall see in Chap. 7 how to undertake credit risk assessment of the client on trade and receivables finance propositions and where this differs to conventional credit risk assessment.

1.15 The Purpose of Trade and Receivables Finance

In conventional ‘balance sheet’ lending a pot of funding is made available based on the client’s credit status, historic and forecast cash generation, and available security. This allows the client to spend the borrowed monies as they deem appropriate.

Trade and receivables finance is an alternative form of financing. It provides finance for trade where the primary source of repayment is the transaction itself rather than the client. The credit facility is drawn to fund specific trade transactions or used as a revolving facility which is utilised subject to the fulfilment of pre-specified criteria.

It is used to generate additional lending appetite or to improve the risk profile of existing lines of finance.

1.16 Trade Finance

The term ‘trade finance’ is used widely in relation to many aspects of supporting or financing a trade-related transaction. This book will focus upon its primary use, which is the provision of credit support or finance to enable the client to purchase, produce, or manufacture goods to fulfil an order they have received from their customer, the end-buyer. The key criterion is that the client holds a committed order from the end-buyer and thus the goods are said to be ‘pre-sold’. It is the proceeds of sale which will provide the financier’s primary source of repayment.

Trade finance can take the form of credit support such as the provision of a credit facility for the issuance of a trade product such as a letter of credit, bank aval,standby credit, or bank guarantee. When these trade products are issued the bank is providing their undertaking to make payment to the beneficiary. They are thus taking credit risk exposure on their client, the applicant, who may not be able to reimburse the bank for payments made.

Trade finance can also be used to fund the gap between the payment for goods purchased and receipt of the related sales proceeds. We shall explore different financing mechanisms within this book. Some will involve the use of trade products such as letters of credit, and others where no trade product is used, such as open account transactions.

Trade finance can only be used to provide credit support or finance for specific types of cost, such as the purchase price of goods and related freight, insurance, and import duty; it cannot be used to fund indirect costs or overheads such as wages.

Payment or finance is released against the receipt of trade documents which evidence apparent performance of the underlying commercial contract, such as the shipment of goods.

Trade finance is typically associated with short-term financings of up to 180days, and receivables finance of 90days or less. Trade financing periods can reach 18–24months for some goods such as machinery and equipment.

Medium-term finance relates to funding periods of between two and five years. Credit terms within this range are often financed against bank guaranteed debt obligations using a method known as forfaiting, using the support of export credit agencies (ECAs) and through the support of contract-specific private market credit insurance policies. Forfaiting is covered in Chap. 11, ECAs in Chap. 9, and credit insurance in Chap. 21.

Beyond fiveyears the transactions tend to be more project rather than trade related. Repayment is based upon forecast cash flows from the completed project. Trade products can be used to support these, particularly bank guarantees and standby credits given the potentially huge performance obligations involved.

1.17 Receivables Finance

A trade receivable is an amount of money claimed from the end-buyer in respect of the delivery of goods by the seller. This may also take the form of an undertaking to pay from the end-buyer, known as a ‘debt obligation’. Many sales invoices and debt obligations are payable at a future date because the seller has allowed the end-buyer time to pay, known as ‘trade credit’. Sales invoices and debt obligations are covered in Chap. 19.

Having expended cash on the cost of purchasing, producing, or manufacturing goods, the seller will need to wait for the end-buyer to pay on the future invoiced due date. This could be 30, 60, 90days, or more after delivery of the goods.

Receivables finance is used to fund the trade credit period so that the seller does not need to wait for payment by the end-buyer on or after the invoiced due date to receive proceeds. Once goods are sold, invoiced, and delivered, the sales invoice can be sold to a financier and an early payment, known as a ‘prepayment’, received from them. This accelerates the receipt of proceeds to the seller while allowing the end-buyer time to pay.

In the case of trade finance, the sales invoice prepayment proceeds can be used to repay the trade financier in respect of their prior funding of the purchase cost of the goods. Receivables finance is described in Chap. 23.

1.18 Structured Finance

Financiers are increasingly moving away from the provision of conventional lending products such as overdraft and revolving loans. This is because of their lack of transparency and control and relatively high levels of credit risk exposure. Financiers are turning to the less risky structured lending solutions of trade and receivables finance.

If the terms of the credit facility require the financier to control the release of funds against pre-specified trade documentation, to take control and security over the goods in transit or in storage, and to capture the sales proceeds of the transaction, this is known as a ‘structured’ facility.

In addition to control, when appropriately constructed, it can provide the financier with visibility over the transaction as it passes through each stage of the trade cycle. This can be achieved by using loans, known as ‘trade loans’. A loan will be drawn or refinanced against documentary evidence of satisfactory progress of the transaction. The maturity date of the loan will be aligned to the next stage of the trade cycle or to the expected receipt of sales proceeds. Failure to receive transactional proceeds to repay the loan, or the non-receipt of documentation evidencing the fulfilment of that part of the trade cycle, will highlight issues or slippage so that timely enquiry, action, or escalation can be made to protect the financier’s position.

When the trade receivable sales proceeds are ring-fenced away from the control or possession of the client and applied by the financier to fully repay the financed transaction, this is known as a ‘self-liquidating’ facility.

Control over the goods and property rights conferred to the financier by the perfection of security in accordance with applicable law means that the financier can take possession of the goods and sell these as a secondary means of repayment. This is an important back-up should the financed transaction fail to conclude successfully or the client defaults on their obligations.

The extent of facility structuring and thereby control over the use of the credit facility, security over the goods in transit or in storage, and the capture of sale proceeds will be determined according to the level of perceived risk.

When the trade transaction will generate an identifiable and more reliable source of repayment than the client themselves and the credit support or financing is provided on a controlled or ‘structured’ basis, trade and receivables finance can generate additional credit appetite and thus enable the financier to lend more in a controlled manner. It is not limited to the credit status, debt capacity, and available security of the client but leveraged by the reliability of the sales proceeds and how these are obtained and captured.

1.19 Banks and Alternative Market Financiers

Banks and alternative market financiers play a very important role in facilitating international trade by bridging the conflicting needs of seller and buyer through the provision of risk-mitigating trade products and structured financing solutions.

Many commercial and state-owned banks who provide credit facilities and services to small and medium-sized enterprises (SMEs) and to the corporate market have trade and receivable finance propositions. These often employ specialist sales teams, who provide client-facing advisory services, working closely with the bank’s relationship or coverage managers to structure solutions and support the application for credit facilities.

Trade products are handled and processed by the bank’s trade operations department. The department also provides technical support to relationship managers and their clients. Some financiers have middle offices which sit between the front-facing relationship team and the volume-based trade operations department. This can be essential to manage a highly structured trade and receivables finance transaction.

There is an increasing trend to integrate the front office of trade finance and invoice finance teams, which historically have remained separate. Given the importance of the invoiced receivable to a trade financier and the benefit of the assessment made by the trade financier on the end-buyer’s purchase order and evaluation of supply chain performance risk, this can provide for a more integrated internal and external risk-mitigating and financing proposition.

In some markets, in addition to banks, independent companies also provide trade and receivables finance facilities. Using their own credit facilities held with a bank, they arrange the issuance of letters of credit and provide trade loans for the purchase of pre-sold goods and the financing of sales invoices. Very often they provide SMEs with credit facilities that the mainstream banks are unable to because the client is not sufficiently creditworthy or has an unproven track record.

These independent providers become more closely involved in the transaction, often purchasing the goods in their own name rather than relying on security over the goods. This enables them to directly enter the value chain. Goods are then sold by them to the client to enable delivery to the end-buyer. The payments, goods, and cash flow of the trade transaction are closely controlled, managed, and monitored. The receivable is purchased by the financier and the risk of end-buyer insolvency protected by credit insurance.

The client is incentivised to do all they can to ensure a successful outcome by providing the financier with personal guarantees. These, along with liquidated sale proceeds of the goods or credit insurance claim proceeds, can be used to repay the credit facility in the event of default of the end-buyer or client.

Because the independent trade financier is taking risk without the benefit of traditional security over the client’s general assets, which are often charged to a bank, pricing is at a premium.

Part ITrade

©The Author(s)2018

Stephen A.JonesTrade and Receivables Financehttps://doi.org/10.1007/978-3-319-95735-7_2

2.Trade Credit

StephenA.Jones¹

(1)

AXS Trade Finance Ltd., Solihull, West Midlands, UK

StephenA.Jones

Keywords

Credit risk exposureDPODSOFinance trade receivablesLiquidityLiquidity riskTrade credit

In any commercial transaction involving the sale or purchase of goods, the seller and the end-buyer will have opposing requirements on the timing of payment. The seller will require payment prior to or on delivery of the goods and the end-buyer will wish to make payment as late as possible to conserve their cash. Compromise will be required to achieve agreement, with the party in the weakest negotiating position conceding most ground.

A seller that has surplus stock to sell which is widely available from other suppliers is in a commercially weak bargaining position, and the end-buyer in a strong one. All other things being equal, the commercial agreement will therefore be closer to the end-buyer’s preferred terms than those of the seller.

If the seller has only a limited supply of unique goods, and the end-buyer needs these urgently, the seller is in a commanding position.

This strength or weakness is important to a financier. A client who is in a weak position is likely to obtain unfavourable commercial terms. This increases risk for both the client and their financier. In Chap. 4 we explore the key clauses within a commercial agreement and the risk implications for the financier.

If an issue arises during the transaction, the financier is reliant on the parties resolving the matter and successfully concluding the transaction. A client that has commercial leverage increases the chances of keeping the transaction alive and on terms which are advantageous to them and their financier.

2.1 Key Requirements of aSeller

Ideally, the seller will not wish to deliver the goods to the end-buyer until they have been paid. This requirement is driven by the need to eliminate the risk of delivering the goods and not being paid for them.

When the goods are to be procured or manufactured specifically to fulfil the order of the end-buyer, the seller may require full payment at the time of order, known as ‘proforma terms’ or ‘advance payment’.

Alternatively, a deposit payment of typically between 10% and 30% of the sales value may be required. This can be higher depending on the needs of the seller and their commercial leverage over the end-buyer. Advance payment eliminates risk for the seller and a deposit payment reduces risk. Both can be used to fund the procurement or manufacture of the goods. The end-buyer may require finance to meet these commercial terms. The risks to the financier and funding structures for supplier payments are described in Chap. 17.

2.2 Trade Credit

When a seller allows the end-buyer time to pay for the goods, this is known as ‘trade credit’. The goods are delivered in exchange for the end-buyer’s agreement to pay at a future fixed or determinable date. The purpose of trade credit is to allow the end-buyer time to generate cash flow and thereby liquidity from the use or onward sale of the goods.

Whilst advance payment or a deposit is advantageous to the seller, it can render their terms uncompetitive and, in so doing, they lose the deal to another supplier. It is often necessary therefore for the seller to offer trade credit to make their sales proposition competitive, particularly when the same goods can be purchased from other suppliers. All other things being equal, trade credit can be the deciding factor for determining which supplier the end-buyer chooses. A seller who is prepared to offer credit, or a longer period of trade credit than their competitors, subject to comparable price, availability of goods, and quality, will win more business.

The end-buyer will seek trade credit to preserve their cash resources for as long as possible. Ideally, they will wish to pay at a future time when they can reasonably expect to have created sufficient liquidity from using or selling the goods. This would make the transaction cash neutral. If the end-buyer is required to pay the seller earlier than this, they will either need to use their cash resources, borrow the money, or fail to pay the invoice when due for payment.

2.3 Credit Risk Exposure

The provision of trade credit terms results in credit risk exposure for the seller. The longer the credit period allowed, the greater the risk that the financial position of the end-buyer deteriorates, rendering them unable to pay the seller when the invoice falls due for payment. Transactions with long credit terms also have an increased likelihood of dispute because the goods may subsequently reveal a fault or be deemed unreliable.

2.4 Liquidity Risk

A seller who has allowed the end-buyer a period of trade credit will need to wait for their money; this exposes them to liquidity risk. The seller will have spent money purchasing raw materials or components for manufacture or procuring finished goods for sale to the end-buyer, which they cannot recover until such time that they have been paid. This depletes the cash resources of the seller, potentially preventing them from paying their workforce and creditors, and taking on new contracts until they have been paid. The longer the gap between expending cash and receiving payment, the greater the seller’s risk of running out of cash.

2.5 Period of Trade Credit

The period of trade credit provided should relate to the nature of the goods being sold. For example, it would be inappropriate for an end-buyer to request one year to pay for the supply of fresh fruit and vegetables. A requirement for trade credit terms of one year to pay for the purchase of machinery could however be feasible, as this would allow the end-buyer to use the machine to produce components and sell these to create sufficient cash flow from which to pay the supplier.

The provision of trade credit or an extension of longer credit terms will have a negative impact on the seller’s cash flow and liquidity, whereas a restriction in the supply of trade credit or a reduction in the trade credit period will have a positive effect. Whilst the seller will ordinarily wish to keep any period of trade credit to a minimum to reduce credit risk exposure and limit the impact on their liquidity, this may result in the loss of business.

Receivables finance, which is explained in Chap. 23, enables the seller to provide competitive trade credit terms and thus potentially increase their business whilst receiving an early prepayment of monies from the financier.

2.5.1 Financier’s Perspective

It is often said that credit is the ‘lifeblood’ of trade. The financier’s role in providing trade products which can mitigate the seller’s risk exposure and finance the trade credit period are fundamentally important services in facilitating global trade. As we shall see in Chap. 21, credit insurance companies also play a vital role in the supply of credit risk management information and insurance against the insolvency of the end-buyer. This can be used by the financier to reduce risk exposure and facilitate the financing of the seller’s trade receivables.

Credit risk assessment of the end-buyer is important to a financier who is either directly or indirectly relying on their settlement of the sales invoice as the primary source of repayment. We shall examine credit risk assessment of the end-buyer in Chap. 20.

2.6 Days Sales Outstanding (DSO)

A key requirement of the treasury or finance function of a seller is to minimise their credit risk exposure to end-buyers and to ensure they have available cash or credit facilities to operate effectively. A key determinant is the length of time that sales invoices take to get paid. This is measured by a ratio known as DSO or days sales outstanding. Those which are paid more quickly shorten credit risk exposure and liquidity risk, described within Sects. 2.3 and 2.4, respectively, and reduce the need to borrow.

A seller will therefore target a reduction in their DSO ratio by introducing measures to receive monies more quickly from the end-buyers. These actions may involve the reduction or restriction in the provision of trade credit, improvement in credit control, implementation of a more rigorous process for chasing end-buyers for payment or selling their sales invoices to a financier for a prepayment.

DSO is calculated as follows:

TRADE DEBTORS × 365

ANNUAL TRADE SALES

End-buyers are often referred to as ‘debtors’. A company will record the value of outstanding sales invoices in a debtor report or listing. This is shown in their financial statements as ‘trade debtors’.

DSO Example

A company has annual trade-related sales of USD 7,548,635.

The average amount of outstanding sales invoices that they have issued is USD 1,323,597.

The DSO of this company is 64 days.

Calculation: USD 1,323,597÷USD7,548,635×365 = 64

2.6.1 Comment

This ratio can be used to monitor and manage the average DSO of all the seller’s trade-related sales or the DSO for specific end-buyers.

DSO should be compared with the period of official trade credit allowed by the seller as a measure of how long it takes the end-buyer(s) to pay after the invoiced due date. Where statistics are available, a comparison with the industry average will provide an indication of how the company compares with their competitors.

Analysis of DSO is provided in Sect. 7.9.

2.7 Key Requirements of aBuyer

As a minimum a buyer will not wish to pay for the goods until they have been received, inspected, and deemed satisfactory. Ideally, they would like to have sufficient time to use raw materials or components as an input for manufacture, if applicable, to sell finished goods and receive payment from their own customers to generate cash from which they can pay the supplier.

This requirement is driven by the need to preserve cash. If the buyer was to pay the supplier earlier, they would deplete their own cash reserves or need to borrow the money. The buyer will therefore wish to pay the supplier as late as possible either by negotiating the required trade credit terms, or by delaying payment beyond the invoiced due date.

In practice, there will often be a shortfall in the period of trade credit received, and thus the transaction will deplete the cash resources of the buyer or finance will be required to pay the supplier.

2.8 Days Payables Outstanding (DPO)

A key requirement of the treasury or finance function of a buyer is to improve their cash flow and liquidity. One way this can be achieved is to increase the length of time taken to pay their suppliers.

This is measured by a ratio known as DPO or days payables outstanding. This ratio represents the time taken to pay invoices received from suppliers, known as ‘trade creditors’. Invoices that remain outstanding for longer, because of either an increase in trade credit terms received from the supplier or invoices that are settled more slowly, improve cash flow, and thus reduce the need to borrow.

A buyer will therefore target a lengthening of their DPO ratio to generate measures that will result in paying their suppliers later. These actions could be to negotiate trade credit or the extension of longer trade credit terms, or delay payment after the invoiced due date.

Alternatively, buyers could use trade products such as a letter of credit or bank aval. These provide a financing mechanism for the supplier, which enable them to grant potentially much longer credit terms to the buyer but receive payment early from the financing bank.

DPO is calculated as follows:

TRADE CREDITORS × 365

ANNUAL TRADE PURCHASES

Suppliers of raw materials, components, or goods are often referred to as ‘trade creditors’. A buyer will record the value of outstanding supplier invoices in a creditor report or listing. This is shown in a company’s financial statements as ‘trade creditors’.

DPO Example

A company has annual trade-related purchases of €4,529,181.

The average amount of outstanding invoices from their trade creditors is €806,567.

The DPO of this company is 65 days.

Calculation: €806,567 ÷ €4,529,181×365=65

2.8.1 Comment

This ratio can be used to monitor and manage the average DPO of all the trade purchases or the DPO for specific suppliers.

DPO should be compared with the period of official trade credit provided by trade creditors as a measure of how slowly the company is making payment after the invoiced due date. Where statistics are available, a comparison with the industry average would provide an indication of how they compare with their competitors.

Analysis of DPO is provided in Sect. 7.10.

2.9 Early Settlement

Sometimes it may be beneficial to pay the supplier early, prior to the invoiced due date for payment. This will apply when the supplier has offered an attractive discount in the cost of the goods for early settlement. To take advantage of this, the buyer will need to have either sufficient liquidity to pay early or available facilities to fund this.

Consideration will need to be given to the opportunity cost of using the company’s cash to pay early, or the cost of finance, in comparison with the discount that can be achieved in the cost of the goods.

Stephen A.JonesTrade and Receivables Financehttps://doi.org/10.1007/978-3-319-95735-7_3

3.The Trade Cycle

StephenA.Jones¹

(1)

AXS Trade Finance Ltd., Solihull, West Midlands, UK

StephenA.Jones

Keywords

Cash conversion cycleCredit facility requirementGoods in transitManufactureTrade cycleTrade receivableTrigger pointsWarehousing

The trade cycle maps out the timeline from commencement of the transaction to its completion, plotting the time flow of goods, documentation, and money. This is important to understand the risks of the transaction, calculate the credit facility requirement, and structure the right financing solution. An example of a trade cycle timeline is shown in Fig. 3.1.

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Fig. 3.1

The trade cycle timeline

3.1 Order Lead Time

The trade cycle timeline starts with the receipt of the purchase order from the end-buyer. The order must be considered acceptable to the financier and represent a commitment to purchase. This is the catalyst for the client placing their order on the supply chain for the purchase of raw materials, components, or finished goods.

Where an advance payment or deposit is to be paid prior to shipment of the goods, this must be plotted on the timeline. Depending on the lead time, an advance payment may be required 30 or 60days prior to shipment, in some cases longer. This provides security of payment to the supplier and a source of funding for production of the goods. If finance is required by the client at this point, it presents the highest risk for the financier. Having made a payment, the goods may never be shipped, or they may be received too late, or they may not be of the correct specification, quantity, or quality. Risk considerations and funding structures for supplier payments are discussed in Chap. 17.

If a letter of credit is to be issued this must also be annotated on the timeline. This will create a liability for the bank on the date of issuance, even though payment may not be made until several months later. Calculation of the letter of credit facility requirement will need to cover the period from the time that the credit is issued to the date of its expiry plus any trade credit payment term allowed. Letter of credit facility calculation is covered in Sect. 12.12.

3.2 Goods in Transit

On a structured facility the financier will wish to exercise control over the goods as they move through the trade cycle timeline. This is particularly important if the financier needs to take possession of the goods and sell these as a secondary means of repayment in the event of default. Key aspects of transactional control during transit are the method of shipment and nature of documentation. The construction of the timeline will prompt important questions around the logistics of movement and the extent to which goods can be controlled. Transportation and control of goods is discussed in Chap. 5.

The length of time that goods are in transit and the period for clearance through customs should be recorded.

3.3 Manufacture

When the client is to manufacture the goods, the financier is exposed to potentially considerable performance risk. Reliance is placed upon the timely receipt of raw materials or components from the supply chain. These must be of the correct specification and quality to enable the client to commence or complete manufacture. The client must possess the expertise, manpower, capacity, and financial resources to assemble or manufacture materials into finished goods and pack them within the required timescale.

The manufacturing period is critical to order fulfilment and timely onward delivery. The trade cycle timeline period should be realistic and ideally incorporate additional time for slippage. One of the purposes of the timeline is to validate that the goods can be obtained, produced, and delivered to meet the delivery date requirements of the end-buyer. Failure to achieve this could result in order cancellation or penalty cost.

3.4 Warehousing

Finished goods may need to be placed in storage until the end-buyer is ready to take delivery.

The anticipated time that goods will be stored in a warehouse must be carefully considered and plotted. Where possible the period should be validated by referral to the client’s financial statements. The average number of days that stock was held during the reported period can be calculated using the ‘days inventory outstanding’ (DIO) ratio. This is described in Chap. 7.

Where goods are held in storage against call-off by the end-buyer, either by means of a delivery schedule or by receipt of purchase orders, the contract ought to specify the final date by which the contracted quantity of goods must be taken by the end-buyer. This ought to be built into the timeline and triggers incorporated into the funding structure to alert the financier of slippage.

The financing of goods held in a warehouse is described in Chap. 18.

3.5 Delivery

The end-buyer will usually specify a latest date of delivery or delivery window within their purchase order. The consequences of late delivery should be clear and understood. This may involve a penalty or order cancellation.

Where the delivery date is ‘of the essence’, the trade cycle timeline must demonstrate that this can be achieved. If it cannot it is better for the client to renegotiate the terms rather than the financier find halfway through the