Understanding Export Credit Risk and Working Capital Drain

Exporting can create new market opportunities, increase revenues, and give you competitive advantages, but it brings significant financial risks to the table. Export credit risk occurs when an international buyer delays payment or fails to pay. This creates uncertainty in the cash flow, while exporters are typically putting themselves at a working capital drain. These challenges can strain even the best-managed businesses. But what exactly is the link between export credit risk and working capital drain? This article discusses this link in detail and outlines practical steps to minimize its impact.

What is Export Credit Risk?

Export credit risk refers to the risk that a foreign buyer will not pay for goods or services supplied through credit. There are many reasons why a buyer may not pay; for example, the buyer goes bankrupt, there has been political turmoil in the buyer’s country, inconvertibility of currency, or any other commercial or political disruption. 

It is important to note that when dealing with international trade, payment terms are often longer. Therefore, the chance of issues with delayed and defaulted payments due to longer lead times in terms of logistics and complexities associated with trading cross-border increases compared to domestic trade. Exporters face potential risks like: 

• Buyer insolvency or bankruptcy.
• Political unrest/war/sanctions impacting payments.
• Fluctuations in currency make payments unrecoverable.
• Regulatory changes or restrictions placed on imports.
• Export logistics and/or payments are delayed during transit. 

Export credit risk management can help develop measures that support exporters in managing cash flow, making informed credit decisions, and confidently entering international markets. 

How Export Credit Risk Causes Working Capital Drain?

Working capital refers to the funds needed for short-term operations, including buying raw goods, production, salaries and wages, shipping, etc. For exporters, working capital is closely related to cash flow cycles. 

• The funds are tied up in accounts receivable and, therefore, are not freely available as liquid cash.
• Payments are not made promptly, which can limit the ability to pay suppliers and other operating expenses.
• Exporters will usually need to find costly short-term financing to cover the cash flow gap.
• There is an added risk of bad debts that exporters may need to reserve funds or write-off provisions for.
• When there is no fixed time for payment, it is difficult to forecast and plan working capital.

Working capital issues can limit the growth of a business or profitability, and in extreme cases, undermine the future viability of the export operation.

Comprehensive Export Risk Management Strategies

Export credit risk can be reduced, and the impact on working capital can be lessened by using a variety of risk management strategies as follows:

Credit Risk Assessment:

• Perform thorough credit assessments of foreign buyers before extending trade credit, including credit history, financial stability, and past payment behaviour.
• Monitor your foreign buyers’ financial health and changes in the geopolitical environment affecting their country.

Market Diversification:

• Distribute export sales to different countries and customers to limit risk concentration.
• Avoid over-reliance of buyers in one market, or on a few buyers, when there may be a risk of political or economic shocks. So, it is important to make sure your buyers are diversified.

Export Credit Insurance:

• Purchase export credit insurance for the risk of non-payment due to commercial or political/sovereign reasons.
• Select insurance policies for short-term, medium-term, and long-term risks.
• Take advantage of government-based insurance systems, such as those of Export Credit Agencies (ECA), for additional backing.

Export Financing Instruments:

• Use Letters of Credit (LCs) for payment guarantees from banks, pending contract performance.
• Employ documentary collections involving both banks in document transfer control and payment.
• Use export factoring to sell accounts receivable at a discount value to convert them into cash immediately and transfer credit risk.
• Employ forfaiting to sell medium or long-term receivables without recourse.

Currency Risk Management:

• A good recommendation for hedging foreign exchange exposure is using forward contracts, contracts for currency options, or foreign exchange swaps to mitigate losses due to currency fluctuations.
• Invoicing in stable currencies or buyers’ currency preferences minimizes FX exposure.

Legal and Contractual Safeguards:

• Contracts should contain very specific information on payment, documentation, defaults, and dispute resolution clauses.
• Internationally accepted trade rules/provisions should be incorporated to reduce uncertainty, e.g., Incoterms.
• Verify compliance with export controls and international trade practices with the assistance of an attorney/legally trained professional.

Key Export Finance Solutions to Manage Working Capital Drain

The following are some of the key export finance tools used to improve working capital and to limit export credit risk:

• Letters of Credit (LC): A bank-issued guarantee for the exporter to receive payment upon meeting the terms of the contract. It is generally used to reduce the risk of default on payment.
• Export Factoring: The sale of accounts receivable to a factoring company at discounted rates is called export factoring. It provides a means to get cash from receivables immediately and transfer the associated credit risk to the factoring company.
• Forfaiting: The sale of a medium- to long-term receivable to a forfaiter; provides guaranteed immediate funds without recourse.
• Export Credit Insurance: Insurance against buyer insolvency and/or against political risks and, possibly, non-payment.
• Foreign Exchange Hedging: Financial instruments such as forward contracts that lock the exchange rate in a way to stabilize the value of the receivable in your home currency.

These financial instruments can help the exporter manage its working capital cycle positively through liquidity, risk management, and reduced liabilities.

Working Capital Challenges in Exporting and How to Overcome Them

Exporters face a unique variety of challenges associated with working capital management, including:

• A longer credit period leads to longer cash conversion cycles.
• Increased administration costs from overseas transactions. 
• Economic uncertainty and global supply chain challenges.
• Costs of interest and financing of short-term funding needs.

Exporters can manage these challenges in different ways: 

• Implement systematic credit control and collections procedures.

• Hold enough cash to cover operations and contingency funding.
• Monitor market and buyer risks on an ongoing basis to adjust their credit terms when necessary.
• Focus on inventory and other supply chain efficiencies to reduce the amount of cash tied up in operations.

The combination of finance and export risk management strategies not only enhances an exporter’s working capital position but also prepares them for growth and resilience.

Managing Export Risk and Working Capital

Export credit risk and working capital drain are two major challenges exporters need to pay close attention to if they want to grow their businesses internationally. By carefully assessing these two issues, exporters can smoothly move on with their business.

Platforms like Credlix enable exporters to have financial access to a wide variety of flexible solutions. Utilizing modern export finance and trade finance solutions like Credlix will increase your ability to be a competitive, sustainable business in the rapidly changing landscape of international trade.

Frequently Asked Questions

Q1: How do exporters manage export credit risk?

Exporters can effectively manage credit risk by following careful background processes on buyers and undertaking ongoing assessments of each buyer’s creditworthiness. 

Q2: What financial instruments provide help with the drain on working capital for exporters?

Financial instruments commonly used to support working capital management include export factoring, forfaiting, letters of credit, and export credit insurance. These instruments generate cash flow immediately and protect exporters from buyer default and transfer.

Q3: Why is an extended payment term a greater risk for exporters?

When a payment term is extended, the length of time an exporter’s cash inflow is held in accounts receivable is prolonged. This could impact the exporter’s ability to pay operating costs, suppliers, or place additional orders.