Trade finance and InCoTerms are highly related in so many aspects. When applying for trade finance services, the incoterm is one of the (many) variables considered when assessing the application. As a company involved in international trade, you can’t avoid Incoterms.
A universally recognised set of rules that guide buyers and sellers, Incoterms ensure a mutual understanding and avoid mistakes when formulating and fulfilling a contract for the shipment of goods.
“Incoterms” is an acronym standing for International commercial terms. First introduced in 1936 by the International Chamber of Commerce (ICC), Incoterms 2020 marks the first update since 2010 – and the ninth version overall – each designed to keep pace with the continually evolving global trading landscape.
The Incoterms rules feature abbreviations for commonly used terms which all have very precise meanings for the sale of goods and are universally understood by buyers and sellers around the world.
A basic understanding of Incoterms and Trade Finance
Incoterms 2020 consists of 11 terms which are grouped under four separate categories based on the first letter of each term:
– Departure (E) e.g. EXW (Ex Works)
– Main Carriage Unpaid (F) e.g. FOB (Free on Board)
– Main Carriage Paid (C) e.g. CIP (Carriage and Insurance Paid To)
– Arrival (D) e.g. DDP (Delivered Duty Paid)
Each group’s letter makes up the first letter of the Incoterm. For example, if your agreement with a buyer calls for the release of goods by the seller at the seller’s location, Ex Works (EXW) would be used because it confirms that the buyer takes over carriage and insurance responsibilities at the seller’s dock. Alternatively, if the seller were to deliver goods to the buyers dock, including all carriage, insurance and duties paid, a term from the Arrival group such as DDP (Delivered Duty Paid) would be appropriate. DDP represents the most obligations for the seller, whereas EXW represents the least.
Costs to consider when selecting the right Incoterm
Changing the Incoterm of an international trade contract should not be taken lightly and need to be the subject of detailed discussion between the buyer, shipper and financial intermediaries.
There are many implications for shipment arrangements, customs clearance, import and export tax liability, local transportation and insurance of goods, as well as – inevitably – for product pricing.
When taking responsibility for shipping, it is necessary to ensure that all documents are in order to meet customs clearance requirements, including shippers export declaration, Certificate of Origin, bill of lading or airway bill, purchase order, invoice, packing list, manifests (including details of the cargo, the shipper, consignee, weight, measurement and packing list), export and import licences (if required), as well as any other specific documentation as specified by the buyer, or as required by financial institutions or L/C terms or as per importing country regulations. The arrangement of physical inspection of goods is also necessary to complete this process.
In addition to document preparation and submission, payment of relevant taxes is essential, including customs tariffs, VAT (where applicable), with Tax free zones also taken into account.
Shipping duties also require co-ordination of physical transportation, both locally – taking delivery of cargo from the factory and from customs after clearance along with documents – as well as international cargo shipment.
How Incoterms affect trade finance opportunities
Familiarity with Incoterms often means that buyers and sellers take the easy option by following standard industry practice or simply sticking with the terms used in a previous sales agreement with the same customer.
In fact, there are some good reasons why SME manufacturers should carefully consider their choice of Incoterms for upcoming contracts.
One of the key benefits to selecting specific Incoterms is the opportunity to obtain more favourable trade finance.
Invoice Discounting is an increasingly popular form of trade finance that involves funding an invoice – which is a tradeable asset with a tangible value – so that the manufacturer can obtain working capital to cover the production and shipping of goods that will only be paid for by the customer some 30-90 days later.
However, an invoice can only be financed after the point at which transfer of risk for the goods takes place between the seller and the buyer. So if a seller wants to maximise the length of funding, it is important to select Incoterms that brings forward the transfer of ownership to the buyer as early as possible.
For example, this might mean considering FCA (Free Carrier) or FOB (Free On Board) rather than DPU (Delivered At Place Unloaded), DAP (Delivered At Place) or DDP (Delivered Duty Paid).
This chart provides an insight into changes made to the point of delivery and transfer of risk in Incoterms 2020.
A final word on Incoterms
It is important to reiterate that successful completion of a trade order is not dependent solely on the choice of the most appropriate Incoterms – it also depends on a carefully drafted contract that satisfies buyer and seller equally.
Nevertheless, with information provided by a partner such as Velotrade, a seller can arrange more favourable terms for its international orders under Incoterms 2020 and open the door to more effective trade finance.