Cotti-Trade-and-Treasury_Cottis_Insights_01

Corporate Series

The objective of this section is to provide insights into the Corporate’s world when executing cross border commercial activities. We will address topics like Core Commercial Needs, Key Trade Risks, Asset Conversion Cycle, Working Capital etc.

In order to settle a commercial contract, the needs of a company can be categorized into 4 Basic Commercial Needs:

  • Settlement

The settlement of a commercial contract entails the handling of all relevant documents to move the goods, to clear customs and to trigger the payment including payment assurance methods and the actual payment itself.

  • Risk Mitigation

Risk mitigation is any form of protection that a company can arrange to protect itself from any of the risks mentioned in section 1.2.

  • Finance

Finance is any form of providing liquidity into the physical supply chain to ensure that there is enough working capital and cash flow with either the buyer or the seller or the trader or the buyer’s bank to guarantee the smooth settlement of the commercial activity.

  • Information

Information is the sharing of key data points either physically through documents or electronically through technology to ensure the right information is at the right location with the right party involved to guarantee a smooth and efficient settlement of the commercial activities.

Here are the 8 Key Trade Risks that occur when executing a cross border commercial contract:

1.  Counterparty Risk

This is the primary risk concern for corporation involved in cross border commercial activities.

1.1 Counterparty Risk – Buyers ability to pay

This buyer’s payment risk is the risk on the buyer who is to make the payment. His ability and willingness to repay needs to be assessed either in the context of the on-going commercial relationship or in the context of a specific contract or a project.

1.2 Counterparty Risk – Supplier’s Performance Risk

Every buyer is dependent on the performance of the supplier to manufacture and deliver the underlying goods as per the commercial contract. This risk is the risk on the seller that he actually performs his obligations under the commercial contract.

1.3 Counterparty Risk – Bank Risk

This is the institutional risk on bank counterparties to ascertain that a bank is able to meet its stated obligations and is experienced to deliver Trade Finance services in time and with quality.

2. Political/Country Risk

This is the risk connected with the political (and economic) stability of the government / country to honor its foreign exchange liabilities and to let the companies in its jurisdiction freely execute their commercial activities and import and export goods and funds at their discretion.

3. Sovereign Risk

Sovereign risk needs to be clearly distinguished from political/country risk. Sovereign risk is so termed when the buyer and the obligor of the finance transaction is a government.

4. Transfer Risk

Transfer risk assesses the risks involved in physical movement of the foreign exchange from the paying country to the recipient country. On many occasions the buyer has paid the local currency equivalent to his bank/central bank for remittance to the beneficiary bank; but the seller depends on the country’s own exchange reserve to be sufficient to effect the conversion/transfer and honor the obligations.

5. Transportation Risk

This is the risk that occurs at various stages of the transaction where the issue of movement of goods arises. Such risks could be direct or indirect. Direct risks are those where goods do not reach the destination by the determined time or are damaged en-route. Indirect risks are those where the transport company fails to deliver the goods in time or not at all thus affecting the production process of the buyer.

6. Price Risk

When a product is bought at a particular price to be on-sold at a higher price and the market price significantly changes so that the buyer is trying to find ways not to honor the transaction and source cheaper elsewhere or trying to negotiate a significant discount that can erode the margin or has to complete the transaction and occur a loss.

7. Exchange Rate Risk

This risk occurs when the underlying commercial contract is a different currency to the currency the seller requires and a foreign exchange transaction is required. This can have significant impact on the sellers profits as the foreign exchange market can move into a non-favorable direction and the seller will obtain much less value in his currency.

8. Documentation Risk

This is the risk that the underlying documents are genuine and sufficient to complete the commercial contract and to clear customs in the exporting and importing country. It is also the risk that the banks involved in the settlement of the various settlement options handle the documents with care and in time and in line with their roles and responsibilities according the various international standards and market practices.

Any company’s commercial activity can be split into 2 main activity fields, the Physical Supply Chain and the Financial Supply Chain. The Physical Supply chain covers all the activities and processes to purchase, manufacture and sell the physical goods and services whereas the Financial Supply Chain covers all financial activities and processes such as arrangement of risk mitigation and financing instruments, the assessment of the financial risks (credit assessment, payment risk etc.,) and the overall working capital, liquidity, documents and funds flow management.

However, it is important to recognize that the physical and financial supply chain are inter-related and drive the Asset Conversion Cycle (ACC) of a company. The ACC is the time it takes for a company to purchase raw materials, convert those materials into finished goods, sell them and receive payment.

Working Capital Management is the umbrella term for a Corporation to ensure that their short-term working capital requirements are met to fund its day-to-day business operations. Having access to short term working capital and liquidity (normally the time horizon is less than one year) is key to every corporation to ensure that the lifeblood of cash is available at every corner of the company at any point during the Company’s Operating Cycle.

company-operating-cycle

As the table shows, there are three major outputs as a result of the Operating Cycle activity:

  1. Accounts Payables are created by the procurement of raw material, components or any type of services and represent a future OUTFLOW of cash
  2. Inventory is created by the procurement of raw material and components and stays with the company till the finished goods leave the company in form of a sale
  3. Accounts Receivables are created by the sale of finished goods or services and represent a future INFLOW of cash

Accounts Payables are promises a company makes to pay a supplier, service provider or utility at a later date to Trade Creditors. They are recorded on the liability side of the balance sheet as the company owes this money to third parties and are like debt
Inventory represents the cash a company has paid for raw material or components that have not been manufactured, processed and sold yet. They are recorded on the asset side of the balance sheet as they belong to the company and have a value.
Accounts Receivables are promises to pay for the sold goods at a later date a company receives from its clients (Trade Debtors) . They are recorded on the asset side of the balance sheet as they belong to the company and have a value.

The importance of the flow of goods and the flow of cash that result from the various procurement cycles of a company are illustrated on the following chart:

procurment-cycle

The Cash Conversion Cycle Measurements

The following chart is illustrating the cash conversion cycle measurements:

operating-cycle

Inventory Management – Days Inventory Outstanding (DIO’s)

Seasonality is impacting sales, inventories, debtors and are higher at certain periods and lower at others. This is impacting the need to hold inventories. Different industries have different inventory needs, companies that have a short production time usually require less inventory than companies where the production process takes a longer time. Managing the right level of inventories is one of the top priorities of any company.

The technical term is called DIO – Days Inventory Oustanding, which is the number of days it takes to sell the inventory(ies).

Sales Management – Days Sales Outstanding (DSO’s)

The risk management function of a company is determing the credit worthiness of clients and the credit period clients are being given when goods are sold to them. If trade debtors are taking too long to settle their bills or if the risk management function is poorly executed, the Working Capital needs will immediately go up as the cash is flowing into the company with delays.
Some industries have longer credit periods before trade debtors need to settle their invoices which is equally driving a higher Working Capital requirement.
The technical term is called DSO – Days Sales Outstanding, which is the number of days for which cash is tied up in receivables.

Supplier Management – Days Payments Oustanding (DPO’s)

At the same time, it is relevant for a company to negotiate credit and payment terms with suppliers. The longer the credit offered by the suppliers, the better for the working capital of the company as it delays the cash outflow.
The technical term is called DPO – Days Payments Outstanding, which is the number of days these payables are outstanding.
Working Capital Facilities

Effective Working Capital Management is a crucial task of every company’s treasury function. It is about balancing the various drivers of Working Capital and constantly monitor and adjust the impacting factors to be on top of the cash flows and to ensure the all the right people, systems and reporting tools are in place to monitor and manage the company’s working Capital.

Working Capital funding can be available from banks or non-bank lending institutions (hereby collectively known as “banks”). In general there are three forms of working capital funding. The most classic one are the provision of an overdraft facility on their operating account(s) that allow companies to temporarily overdraw their account to pay bills, salaries and purchases.

Another form of working capital funding is to have a bilateral working capital loan in place that is traditionally short term with the use of funds not directly monitored or controlled by the banks. This gives the Corporation the flexibility to use the funds where they are needed as long as this is done within the description of the use of funds in the underlying lending facility. The market generally considers working capital loans to be less than one year in tenor.

The third form of working capital funding is when Corporations access Trade Finance facilities from their Banking relationships that are either general in nature to support a re-occurring trade flow or they are specifically structured to support a specific transaction or project. The advantage of this type of financing is that the tailored facility meets the corporation’s specific funding requirement linked to a specific commercial contract or a trade flow. The market generally considers trade finance facilities to be less than one year in tenor although in some instances they can be longer where there is a justifiable underlying commercial need of the asset conversion cycle in the physical supply chain.

Trade Finance is an important aspect of managing a company’s Working Capital and is an integral part of the treasury function. It is important to leverage risk transfer and finance instruments that secure and accelerate cash flow from the commercials activities and hence optimise the Working Capital. The next table shows how the Trade Finance instruments and programs fit into the procurement cycle of a company:

Trade-finance-instruments

Treasury Management or also called Cash Management is equally an important aspect of managing a company’s Working Capital. It encompasses everything from Payments, Accounts and Liquidity to Trade Finance and Foreign Exchange. Streamlining processes, matching cash collections and disbursements, making cash forecasts and cash budget and managing the company’s surplus cash efficiently are critical tasks in optimising a company’s Working Capital.

treasury-challanges-objectives

 

Product Series

The objective of this section is to provide a holistic overview of available Trade Finance Products when executing cross border commercial activities.

The Traditional Trade Finance Solution Set can be split into two main categories:

I. Settlement & Risk Mitigation driven instruments that are usually short-term (up to one year tenor but in support of certain industries can also have longer tenors), documentary in nature by handling all the required documents and provide payment assurance and / or trigger points for the payments and the payment itself. These instruments satisfy the settlement and risk mitigation need of a company.

1.1 Documentary Collections (DC)

1.1.1 Documents against payment

1.1.2 Documents against acceptance

1.2 Letters of Credit (LC)

1.2.1 Documentary Letters of Credit – Availability

1.2.1.1 Sight L/C’s

1.2.1.2 Usance LC’s (deferred payment/acceptance)

1.2.1.3 Negotiation

1.2.2 Documentary Letters of Credit – Risk Mitigation

1.2.2.1 Unconfirmed L/C

1.2.2.2 Confirmed L/C

1.2.3 Standby Letters of Credit (SBLC) or Guarantees

1.2.3.1 Performance SBLC

1.2.3.2 Financial SBLC

1.3 Open account / Purchase Order handling

II. Finance driven instruments that are usually short-term (up to one year tenor but in support of certain industries can also have longer tenors) and provide liquidity to either buyer or seller or the buyer’s bank. These instruments satisfy primarily the finance need but also provide risk mitigation cover.

1.4 Trade Loans

1.4.1 Import Loans

1.4.2 Export Loans

1.5 LC Financing

1.5.1 Negotiation / Acceptance

1.5.2 Bills of Exchange / Promissory Notes

1.5.3 LC Refinancing / Post shipment financing

1.6 Forfeiting

1.7 Factoring

The Supply Chain Finance Solution Set can be split into three main categories:

I. Buyer-Centric SCF – Supplier Financing

Supplier Financing (also known as Reverse Factoring)
Supplier Financing allows the Supplier to get financing based on the credit rating of the Buyer, which usually is a cheaper source of finance then what a supplier has to pay to his bank. The Supplier issues an invoice in line with the underlying Purchase Order and sends it to the Buyer for approval. The Buyer must “approve” the invoice and commit to pay the Bank at the agreed payment date of the invoice, which depending on the Industry and the agreement in the underlying commercial contract can be 30 to 360 days later. The Bank will then finance the invoice and pay the Supplier up front which allows the Buyer to extend his payment terms (DPO) while the Supplier receives its funds at the original payment terms or even earlier and therefore he shortens his DSO.
At maturity, the Buyer repays the full invoice amount to the financing Bank. Supplier Financing programs are usually transacted via electronic platforms which are offered by banks and by non-bank providers.
Supplier Financing has a positive effect on both the Buyers and the Suppliers working capital as it extends the DPO for the buyer and shortens the DSO for the supplier which in turn enhances the cash conversion cycle for both.

Supplier-Financing-Buyer-led-structure

 

II. Supplier Centric SCF – Receivables Financing

Accounts Receivable Financing allows the Seller to discount its invoices with a Bank and as such to reduce DSO and accelerate cash flow. Once an invoice is issued, the Seller presents it to the Bank for discounting. The Bank would then proceed to fund a percentage of the invoice to the Seller – usually on a “with recourse” basis unless the Buyer is notified and commits to pay to the discounting Bank at maturity. The LTV (Loan-to-Value ratio) of a discounted invoice depends on the credit standing of both the Seller (with recourse financing) and the Buyer (without recourse financing). The Seller receives discounted proceeds up-front, rather than having to wait for the Buyer to settle it under the agreed upon payment terms (eg 30/60/90 days). Receivable financing is an ideal solution to improve short-term cash flow.

receivable-financing-without-recourse-to-seller

 receivable-financing-with-recourse-to-seller

III. Vendor / Distributor Finance

There are many specialised Trade Finance techniques available that cater for the many variation of the asset conversion cycle, which can be very different from industry to industry. In general, the market is grouping them as follows:

· Commodity Finance

Inventory/Commodity Repurchase Structure

The use of Repurchase Agreements (in short “Repos”) is an alternative to a traditional bank loan. It works for any type of goods that have a liquid market or an official exchange where the goods can be readily sold. Repos are mainly used for commodities (Agriculture, Metals & Mining, Natural Resources and Energy). The Company acts as Seller, and the Bank as Buyer of the inventory/goods. The Bank buys the Inventory at an agreed upon price, and the Company agrees to repurchase it at a future date and at an agreed-upon future price, plus interest.

The advantage of a Repo vs. a traditional / asset based loan is that ownership of the goods transfers from the Company to the Bank. This reduces the Inventory/DIO and as such improves the Company’s working capital and its cash conversion cycle. In a traditional asset based lending transaction one of the complicating factors is where the inventory/goods are stored. If goods are stored in a country with an underdeveloped legal framework, it will be very difficult for a Bank to obtain a reliable security interest in the goods. A Repo in this respect is much simpler as ownership simply passes from the Company to the Bank, and vice-versa. However, it is important to recognize that a Repo does not achieve off-balance sheet status in every jurisdiction.

From a bank’s perspective, Repo’s are more attractive as Repo documentation is significantly lighter than an asset backed loan, and there are no monitoring requirements. Furthermore, there is less capital allocation to (hedged) Repo’s under Basel II and III (we need external source for this) than there is to a commercial loan. Also, there are daily price quotes on exchanges for the underlying commodity allowing the bank to “mark-to-market” the exposure and if need be goods can be sold on the Exchange to third parties. And finally, the Bank will not use any credit limit on the Company as it “owns” the Commodity. Hence Repos are also a good option for a Company to free up credit limits.

 

Inventory-Commodity-Repurchase-Agreement

· Export Finance

· Structured Trade Finance

There are many forms of Risk Mitigation Techniques available in the market; the 2 most common ones:

· Risk Participation

· Credit Insurance

 

Training Series

World-class professional development. For more information please check the ICC Academy Promotion slides.

 

Digital Trade Finance Series

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