Trade finance instruments explained

Why the distinction matters more than the instruments

A term loan asks whether the business can repay from its general operations. Trade finance asks a narrower question: does this specific transaction generate the cash to repay the facility that funded it?

That narrowing changes who qualifies. A young business with a confirmed order from a creditworthy buyer may have no track record, no security and no audited accounts — and still be fundable, because the funder is looking primarily at the buyer's covenant and the transaction's mechanics.

It is also self-liquidating. The facility is repaid from the proceeds of the transaction, so it does not accumulate on the balance sheet the way a term loan does. For a business whose constraint is that it cannot fund the orders it is already winning, this is usually the correct instrument and frequently not the one it asks for.

Letters of credit

A letter of credit is a bank's undertaking to pay a seller once specified documents are presented — typically proof of shipment. It solves the oldest problem in trade: the seller will not ship before payment, the buyer will not pay before shipment, and neither trusts the other across a border.

The bank's promise replaces the trust. The seller ships knowing a bank stands behind payment; the buyer pays knowing the goods have shipped. Payment is triggered by documents, not by the goods themselves, which is the mechanism's strength and its trap — discrepancies in paperwork are the most common cause of delay, and the discipline of getting documents exactly right is where most of the operational work sits.

Related instruments follow the same logic. A standby letter of credit is a guarantee against non-performance rather than a payment mechanism. Documentary collections are cheaper and lighter, with the bank handling documents but not guaranteeing payment.

Purchase order funding

Purchase order funding advances capital against a confirmed order so the business can buy stock or materials to fulfil it. The funder is underwriting the order and the buyer behind it.

It fits a very specific and very common failure: a business wins an order larger than it can fund, and has to decline it. That is a growth constraint disguised as a cash problem, and it compounds — the declined order usually goes to a competitor who then holds the relationship.

Funders look at three things: whether the buyer is creditworthy and likely to pay, whether the business can actually deliver, and how clean the paperwork is. It is more expensive than a bank overdraft because the risk is concentrated and the assessment intensive. Against declining the order entirely, that comparison usually settles itself. See purchase order funding for the practical route.

Invoice discounting and factoring

Both convert unpaid invoices into immediate cash, and the difference between them matters commercially.

Invoice discounting advances a percentage of the invoice value while the business continues to collect from its own customers. The arrangement is usually confidential — customers need not know.

Factoring sells the invoices to the funder, who then collects directly. Cheaper, and visible to customers, which some businesses regard as a signal of distress and others as routine.

Both address the same underlying problem: profitable businesses running out of cash because customers pay in 60 or 90 days while suppliers and salaries do not wait. Growth makes it worse rather than better, which is why fast-growing businesses fail on cash while showing a profit.

Note the recourse question. Under recourse arrangements the business carries the loss if the customer never pays; under non-recourse the funder does, at a higher price. That single term changes the risk profile entirely.

What funders check before approving

Because the transaction carries the risk, diligence concentrates on the transaction. Funders examine the buyer's creditworthiness first — a confirmed order from a listed retailer is a different proposition from one issued by an unknown counterparty. Then the documentation: is the order firm or indicative, are the terms clear, is there a contract or an email?

Then delivery capability, because the facility repays only if the goods actually ship, and finally the margin in the deal, which must absorb the cost of the facility and still leave the transaction worth doing. Businesses are declined surprisingly often on that last point alone — not because the funding was unavailable, but because the order was too thinly priced to carry it.

Guarantees, and choosing between instruments

Bank guarantees and performance bonds are undertakings to pay if the business fails to perform — frequently required to bid for public or large corporate contracts at all. They are not funding as such; they unlock access to work.

Choosing between all of these is simpler than it looks, because each answers a different question. Money is needed to fulfil an order not yet delivered: purchase order funding. Delivered and invoiced, waiting to be paid: invoice discounting or factoring. Importing and the supplier wants certainty: a letter of credit. A customer needs assurance you will perform: a guarantee.

Where a business needs several of these at once, they are frequently combined into one structure. The full picture for South African importers, exporters and suppliers is in trade finance South Africa.