CORPORATE BANKING SEMINAR

Trade Finance
Arpy T. Al Assad

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Definition of the Letter of Credit
 A letter of credit is an instrument issued by
a bank, at the request of an importer, in
which the bank promises to pay a
beneficiary upon presentation of documents
specified in the letter of credit
 There are basically 3 parties to an L/C:
 The applicant (buyer)
 The beneficiary (seller)
 The issuing bank

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 The relationship between the applicant
and the beneficiary is governed by the
sales contract, while the relationship
between the applicant and the issuing
bank is governed by the terms of the
application and agreement for the
letter of credit.

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Slide of Path of a Letter of Credit

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 Emphasis must be placed on the idea
that a letter of credit is a promise to
pay against specified documents
which must accompany any draft
drawn against the credit

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Documents in letters of credit
 The draft:
 Bill of Lading / Airway Bill
 Additional Documents:
 Signed commercial invoice
 Insurance documents
 Certificate of origin
 Certificates of analysis (weights, purity,
sanitation,..)
 Packing list
 etc

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 The Draft

 Also called a bill of exchange (B/E), is the

instrument normally used in international trade to
effect payment.

 A draft is an order written by an exporter (seller)

requesting an importer (buyer) or its agent to pay
a specified amount of money at a specified time.

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 The person or business initiating the draft
is known as the maker, drawer, or
originator. The party to whom the draft is
addressed is the drawee. The drawee is
asked to honor the draft, i.e. to pay the
amount requested according to the stated
terms. When the drawee is the bank, the
draft is called a bank draft. These are
usually drawn according to the terms of a
letter of credit.

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Drafts are of 2 types:
 Sight drafts, payable upon
presentation to the drawee; the
drawee must pay at once
 Time drafts, also called usance drafts,
allows delay in payment. It is
presented to the drawee who accepts
it by writing or stamping a notice of
acceptance on its face.

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Time drafts allow the importer 60 to 90 days to
pay for the imported goods. By accepting such an
agreement, the issuing bank creates a “banker’s
acceptance” which effectively replaces the
importer’s credit with its own.
In the interim period, the issuing bank must hand
over the shipping title to the goods and is exposed
to the usual risks of lending on an unsecured
basis. Accordingly, the bank may ask its client to
provide additional collateral before accepting time
drafts.

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Bill of Lading
 Is issued by a common carrier
transporting the merchandise. It
serves 3 purposes:
 As a receipt
 A contract
 A document of title

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 Foreign Exchange Risk
 Company may want to hedge against
fluctuation in the foreign exchange
market by purchasing forward currency
contracts in the currencies of its
exporter.

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Case Study

Global Machinery & Metal Company, Inc

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 Objectives of the Case
 The case reviews the mechanics of
international letter of credit (L/C)
financing
 GMMC is requesting an extension of its
credit lines to stock up inventories to
meet the company’s rapid sales growth.
This case demonstrates the usefulness of
financial ratio analysis in determining a
client’s needs to finance additional sales.

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 Case Summary
*GMMC operates as a dealer for new and used machine
tools and also imports finished products from Japan,
Spain and Korea.
*Company’s sales in the Metals Division have shown
rapid growth in recent years and the company now
has about 450 customers in the south and southwest.
*GMMC’s borrowing relationship has been established at
Motor City National Bank since 1992. Mr. Wayne has
requested the bank’s newly-appointed VP, Mr. David
Farmer to increase his firm’s credit facilities.

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Existing Lines of Credit
O/D $ 500,000 @ prime + 2%
Secured by A/R (50%)+ Inventory
(40%)
Actual rest period: 60 days in 1993
30 days in 1994
0 days in 1995
Minimum balance $ 265M
L/C $ 750,000 @ 1% issuance comm
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New Request
Request for increased credit facilities
resulting from the continued rapid
expansion of sales.
O/D line from $ 500M to $ 1,000M
$ 700 to finance an increase in the Machine
Tools Department, remaining for the Metals
Division.
L/C line from $ 750M to $ 1,000M to
finance additional steel inventory to meet
the growing demand for the company’s
steel imports.
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 Financial Ratios

1993 1994 1995

Liquidity
Current 1.48 1.29 1.31
Quick 0.66 0.46 0.38
Leverage
Debt/Asset 0.60 0.73 0.73
Interest Coverage 14.77 7.82 10.59
Activity
Inventory days 140 126 192
Average Coll Period 63 66 67
FA Turnover 20x 32x 38x
Profitability
Gross Margin 36% 28% 28%
Profit Margin 7.4% 4% 5.6%
ROA 15.3% 9% 9.4%
ROE 38.9% 29.1% 35.4%18
 Trade Cycle Analysis
1993 1994 1995
A/R 458 787 972
Inventory 645 1,528 2,480
Trading Asset 1,103 2,315 3,452
Less: A/P 388 746 1,093
Trade Cycle Needs 715 1,569 2,359
Less: Actual NWC 380 544 843
Surplus (deficit) (335) (1,025) (1,516)
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 Trade Cycle
 Trade Cycle Analysis recognizes that funds are
constantly tied-up in Accounts Receivable and
inventory, collectively known as “trading assets”.
Accounts Payable provides a direct source of
financing and is therefore subtracted from trading
assets to find the net working capital needs (the
amount of net working capital necessary to
support the existing level of sale). These NWC
needs are then subtracted from actual NWC to
arrive at the trade cycle surplus or deficit.

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 A surplus indicates the company’s NWC
is sufficient to support the existing
level of sales
 A deficit indicates the company is using
some other current liability (often bank
lines) to support this level of sales

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 Product Mix Analysis
__________________________________________

1993 1994 1995

Sales NI Sales NI Sales Ni
__________________________________________

Metals 45% (14%) 73% 66% 79% 73%

Machine 55% 114% 27% 34% 21% 27%

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 Insert Slide of Cash Flow

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 We should ask WHY?

 The line of credit increase has been

requested primarily to expand the
inventory of the machine tools division,
but the product mix table shows that
this division’s contribution to the
company’s sales and consequently its
earnings have been steadily declining.

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 Strengths
 Price Advantage: GMMC could sell its imported steel
products at prices about 20% less than its competitors who
offered U.S. made products. This has allowed the firm’s
metals division to expand its sales volume rapidly.
 Diversified Market Base: GMMC has found a niche for its
steel products in the south. It has now about 450
customers. While one customer does account for 10% of
the division’s sales, no other customer purchases more
than 3% of its output. Such a diversified clientele does not
allow any customer to gain a monopolistic advantage over
GMMC.

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 Disadvantages

 Being an importing business, GMMC is subject to the

fluctuations in the supply of its merchandise due to
dock strike or import restrictions. GMMC, therefore,
requires its customers to place their orders at least 60
days in advance, while domestic suppliers only need 4
to 6 weeks to respond to orders. To facilitate a steady
supply of its imported products, the company has
been expanding its inventory. The inventory days has
consequently increased from 140 days to 192 days.
 In anticipation of voluntary import restrictions, GMMC
has requested an increase of $ 250M in its L/C line to
finance further inventory accumulation. This would
enable the company to offer an uninterrupted supply
to its growing market.

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