Financial Security And Stability During Intercontinental Transactions

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Design Denim Ltd was founded in late 2008 originally as a work wear contractor for police forces and hotel chains supplying embroidered uniform. Since mid-2009 moved away from the corporate side and now focuses on being a landed supplier of apparel to UK retailers. Since mid-2009 it has moved away from the corporate side and now focuses on being a landed supplier of apparel to UK retailers. It is rapidly expanding by taking on customers such as Marks & Spencer and Tesco, who will be supplied denim Jeans and/or leather jackets. Being a landed supplier Design Denim does not manufacture its own garments; rather it sources from factories abroad in countries such as India, Pakistan and China. An in-house design team will create technical designs and forward them to the production teams at nominated factories who will produce a sample for Design Denim to present to retailers. Once a sample has been selected by a retailer for purchase the customer will send Design Denim an official purchase order. Design Denim will inform the specific factory to commence production by also sending purchase order. The finished goods will be exported to the UK either by ship or by air depending on the urgency of the customer's order. If required the finished goods may be subject to additional processing like bar-coding or labelling. The final stage is delivering the garments to the customer and obtaining a proof of delivery to allow Design Denim to raise an invoice.

Purchasing from overseas suppliers poses a lot of risk as the supplier resides in a different state and can be completely immune to the UK law system. The purchase order is the only form of contractual agreement between Design denim and the overseas supplier, which has potential to be breached.

If UK suppliers were to be used and the goods did not conform, it would be considered a breach of contract and the customer would be able to seek redress (Supply of Goods and Services Act, 1982). However this protection is not offered if overseas suppliers are used. For example a breach of contract could be that the wrong goods are delivered, or the garments are of inferior quality compared to the samples agreed. Also late delivery or discrepancies in the amount of garments delivered could count as non-conformity.

Design Denim has in the past made relatively small losses when purchasing from abroad. The cases vary from lower-grade cotton used in the bulk goods to partial shipments not being met fully. In both these cases Design Denim had paid in full for these goods, and its customer reserved the right to cancel their order. Other possible problems could include orders not being fulfilled, loss of customers and payment being refused due to poor quality goods being delivered. These predicaments will magnify the effect on the company's financial position, due to expenses already incurred during the order. This risk is particularly prominent for Design Denim with regards to registering to supply to Tesco and Marks and Spencer. As these customers will order in larger quantities compared to police authorities. Therefore bigger orders entail larger possibilities for financial insecurity or even bankruptcy. Also Design Denim is a newly established company with limited funds to finance re-purchases, any setbacks could result in calamitous consequences to its financial state.

Non-payment from a customer once the goods have been delivered could also be disastrous for Design Denim. Besides defaulting payment, customers may only buy part of the already manufactured goods and have the power to refuse Design Denim's remaining produce. If the entire order is not sold it could mean a total loss.

The order process involves the customer usually providing Design Denim with a forecast of future requirement for a certain product, which is not a legally binding contract. Without a purchase order to form a commitment to buy, the customer may only buy part of the already produced goods and decide not to take any more. Customers like Tesco have a large degree of power over their suppliers. They have the power to source from elsewhere, so they expect the goods to be manufactured pre-order. jus expand a lil n i also want u to emphasize da fact that you guys manufacture them b4 hand As Design Denim is a newly established company with limited funds, to finance purchases it requires using the cash flow from its debtors.

Identification and description of relevant theories and techniques


Introduction to letters of credit

Other than trading with cash upfront there are various forms of trade finance available that provide security for buyers wishing to purchase from overseas. A letter of credit is a document issued by a financial institution as a source of payment for a transaction.

Letters of credit have been around since 1664 (Walden 1989 cited in Mooney, 1995). A letter of credit (LC) also known as a documentary credit is a contractual agreement between two banks. Payment for the goods would only be made once the buyer's bank is satisfied with the details of the purchase. The buyer's bank, known as the issuing bank will transfer funds to the seller's bank, known as the advising bank only upon receipt of the correct predetermined documents (Trade Finance Guide, 2007). An LC deduces no connection with the sales contract between a buyer and seller as the banks transact only in documents and not the goods. This provides safety for a buyer as any discrepancies such as volume will show up on the documents leading to the issuing bank withholding payment to the advising bank (Trade Finance Guide, 2007). The buyer will apply for an LC and include information such as what they are buying, who they are buying from (the name of the beneficiary), the unit price, the total price and when they except delivery from the beneficiary.

Documents used with a letter of credit

The LC itself is a document; however it relies on additional documents to guarantee protection for both the buyer and issuing bank. Certain documents which the supplier has to produce usually include the commercial invoice, packing list, bill of lading/airway bill, certificate of origin and an insurance policy (Credit Research Foundation, 1999).

The commercial invoice and packing list will contain information on the product such as description, quantity and price policy (Credit Research Foundation, 1999). This information will have been agreed by the buyer and hopefully the invoice and packing list from the supplier will correspond with the buyer's purchase order and the LC. Otherwise

Depending on the mode of transport used import the merchandise, the nominated freight forwarder will either produce a bill of lading for ocean cargo or an airway bill for delivery via aircraft. This document serves as both a receipt of goods by the freight forwarder and evidence of transport to the proper destination (Credit Research Foundation, 1999). The issuing bank will expect the details on this bill to match up with the details on the LC. Otherwise

An additional document that may be required is the certificate of origin. This certificate is of interest to the bank and Design Denim as it guarantees that the goods have come from the supplier and not another party.

2.2 Applying for the LC

Before the LC application is accepted Design Denim will have to supply the advising bank's and the supplier's details to Lloyds TSB (Asad Khan). These details are required by the issuing bank to check the worthiness of providing a high risk facility. Lloyds TSB will have access to more information with regards to the seller's advising bank compared to Design Denim. The issuing bank will be able to inform Design Denim that from previous relations whether or not it is advisable to commence business with such a seller.

Porter's five forces model

Design Denims is in an ever-changing competitive environment. As well as the normal forces that affect every organization the Porter's five forces model focuses more on the immediate competitive environment (Pitts, 2006). The five forces are: the risk of new competitors into the industry, the bargaining power of customers, the bargaining power of suppliers, the concentration of rivalry and the possibility of alternative products (Pitts, 2006). These forces help shape an analysis of the industry's attractiveness.

The threat from new entrants can be determined by the amount of capital prerequisite and the need for economies of scale to operate in this specific industry (Pitts, 2006). A product requiring high capital outlay and the need for continual production to take advantage of economies of scale will be seen to be in an unattractive industry.

According to Pitts (2006) a buyer may hold significant bargaining power if they can backward integrate in the form of producing their own denim garments instead of purchasing them. Marks & Spencer as an example may with their financial strength decide to acquire a factory in India where it can produce its own inexpensive leather jackets and cut out Design Denim.

On the other side Pitts 2006 also states that suppliers will also have great bargaining power if they can forward integrate into the market. An example of forward integration would be one of our factories in China promoting their line of leather leggings on the internet direct to UK customers.

Rivalry and alternate products are the major threat in the fashion industry. There exist multitudes of diverse designs and different materials. In the fashion industry sellers usually approach buyers to pitch their product, meaning switching cost would be low. Pitts (2006) states in an industry where switching costs are low and there is an extensive selection of rival suppliers and products, buyers will unlikely be reluctant to change suppliers.

PEST analysis

PEST analysis, an acronym for political economical social and technological, describes macro-environmental factors that the company has to take into consideration (cited in McGee et al., 2005, p. 13).

Political Factors

Political Factors are a critical consideration when buying and selling products imported from overseas. These factors show to what extent the government intervenes in the economy. Such factors while importing could include trade restrictions on certain products and duty rates applicable once the goods have arrived. Whilst selling political factors include VAT payable on the sales value and that the garments should comply with the strict safety standards.

Economic Factors

Growth and demand in an economy is usually determined by how well the state manages its resources to help promote consumption and business. Other economic factors include: interest rates, which determine the cost of financing purchases and exchange rates, which affect the cost of importing goods. Inflation is a measure of the increase in the general price level (Lawrence & Stoddard, 2009). High inflation rates would mean increased costs.

Lawrence, Jim and Stoddard, Steve. (2009). AQA A2 Economics StudentHYPERLINK ""'HYPERLINK ""s Book. Cheltenham: Nelson Thornes Ltd

Social Factors

Social and culture influences can have a large effect on the fashion industry. Trends in social factors affect the demand for certain products. Aspects that could be looked at are distributions of age and sex, attitudes to foreign products and the roles of men and women in society (Marketing Teacher Ltd, 2010).

Marketing Teacher Ltd. 2010. PEST Analysis. What is PEST Analysis? [Online] Available at: [Accessed 30 March 2010].

Technological Factors

It is essential to fully utilize technology effectively when delivering a product to the market. Technology is crucial to develop a competitive advantage (Marketing Teacher Ltd, 2010).Technology allows for cheaper means of transporting goods using and logistics. Also through the use of I.T it provides innovation and an efficient means of communication between buyers and sellers.

Trade Credit Insurance

Trade credit insurance is an insurance policy for businesses who want to protect their accounts receivable. The policy can covers risks such as insolvency or bankruptcy of the buyer, bank­ruptcy as well as expropriation and changes in import or export regulations (Trade Finance Guide, 2007). The policy would typically cover 90% of the trade debtor balance once annual premiums have been paid.

Debt Factoring

A factor is a financial institution such as a bank that agrees to purchase a business's accounts receivable for cash as soon as the invoice has been raised to the customer. Once the customer has been approved by the bank the supplier will receive immediately cash equivalent to a discounted face value of the invoice (Trade Finance Guide, 2007). Once the customer remits payment to the supplier's bank at a future date, depending on the terms agreed between buyer and seller, the bank will pay the seller the remaining balance less fees and interest. This service will provide Design Denim with cash earlier compared to extending out credit facilities to its customers.

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If for example Design Denim has paid their supplier for the goods and is waiting on the invoice to be paid by Tesco who later become bankrupt and unable to pay, the insurance policy will pay out as agreed.

McGee, J., Thomas, H., Wilson, D. (2005), Strategy: Analysis and Practice, McGraw-Hill, New York, NY

Use of theories and techniques to analyse the identified problem or issue. Critical evaluation of the usefulness and limitations of theories and techniques applied to the problem or issue.

Porter's five forces analysis within Design Denim

This essay is concerned with financial stability so will only focus on a few of the factors within Porter's model.

Porter's five forces focus on profitability as a measure of attractiveness of the industry, and not specifically cash flow while conducting business. However Design Denim's customers such as Marks and Spencer have a certain amount of power over their suppliers, as they expect their suppliers to have their produce ready for sale immediately prior to them giving a commitment to buy. Hypothetically before they issue a purchase order they can legally cancel their future requirement leaving their supplier with unsold produce. Looking at the threat of new entrants in the Porter's five forces model, capital requirements and economies of scale are a barrier to entry. In the denim industry it is only economically feasible to produce five hundred or even up to a thousand units minimum of a single style of clothing. As any amount of units under, there would be inefficiencies in economies of scale. These requirements would mean that Design Denim's suppliers require investing in large machinery and also they can only take advantage of economies of scale if they produce in bulk. Porter's model highlights the risk of buyers having the power to easily switch between substitutes or even suppliers. As Design Denim's customers may in fact cancel their future requirements meaning that the remaining bulk, which Design Denim has had produced, will remain unsold. SOLUTION: Ask for early PO. The resolution to the risk created from this power the buyer has is to actively seek an official purchase order. Buyers will shy away from giving a commitment to buy, just to cover themselves just in case the future holds either better opportunities or their financial position worsens. However with a legally binding contract created through the issued purchase order, the buyer will have to purchase the goods they ordered.

Pitts (2006) describes that a buyer may have the power to backward integrate into the production of leather jackets for example. This is both a risk to the future revenue for Design Denim but at the same time a risk to its current financial position. As previously mentioned, Design Denim may have purchased a large amount of stock hoping to sell it on. However the Porter's five forces model only recognises that buyers may have the power to backward integrate and not the power to approach Design Denim's supplier. Marks and Spencer may be attracted to the quality of leather a certain factory can supply, so employ its design team to order future product lines directly rather than through Design Denim. Design Denim keeps its supplier list confidentially. Yet some buyers such as Tesco may require knowing which country the goods originated from to display to their customers. This proof will come from a request by the buyer to obtain a copy of the certificate of origin, which will also hold information on the factory which produced them. An official document such as the certificate of origin cannot be amended by deleting certain information. To prevent the buyer approaching the factory directly an agreement between Design Denim and their supplier will have to be produced. The contract with the supplier will state that they may not directly do business with Tesco while dealing with Design Denim. With such an agreement in place Design Denim is safe to carry out its purchasing without the risk of loss in the future, because any malpractice by the supplier can be blocked through the law system.

On the other hand the same goes for the seller having the power to forward integrate into Design Denim's market. However, again the Porter's five forces model is limited, as it only recognises that suppliers may have the power to forward integrate and not the power to approach the final buyer. Forward integration is very difficult especially in the high street fashion industry, as a very large marketing campaign, retail outlets and a strong brand identity are required to sell successfully. But the risk to Design Denim is of the overseas supplier approaching Marks and Spencer directly to negotiate future trading. This would cut out Design Denim and may leave it in financial distress. The solution to this problem again would be to create a contract with the supplier stating that they may not contact Marks and Spencer directly to conduct business.

The forces of rivalry and substitute products in the Porter's five forces model are of limited aid to Design Denim due to the industry it is operating in. The fashion industry is where there is relatively low cost for the buyer to switch between products and suppliers as all that is needed is a change in decision. The buyer may have to vet the new supplier and continue with the same process of ordering stock just like it did with Design Denim.

PEST analysis in Design Denim

Government policies are in place to protect the public from hazards from products they purchase. Such hazards could in terms of fire proofing of the material used in the garments Design Denim produces. In the long-term testing will increase costs as every import will have different materials, which buyers such as Tesco will demand be tested for various safety precautions. But in the short-term failing to have completed these official tests could mean an entire shipment will be rejected by the buyer and in serious cases of danger the import could even be impounded by customs. Design Denim will have to get its clothing materials tested by laboratories in order to comply with UK safety codes.

The current increase in VAT may only seem reasonably small as it has shifted from 15% to 17.5%. This rise in VAT can be reclaimed through HM revenue and customs; however it will affect the cash flow of Design Denim. VAT due cannot be withheld from payment as immediate payment is required or the import can be impounded. VAT along with the duty rates can cause cash flow problems as the goods have not yet been invoiced. Design Denim can negotiate with the Lloyds TSB debt factoring service for the bank to pay VAT and duty on their behalf in advance. This would free up cash flow and leave Design Denim in a stable financial position, but at the expense of profit with fees and interest.

The UK economy is recovering from recession. Recession is defined as two consecutive periods of negative economic growth (Lawrence & Stoddard, 2009). Demand for goods and services are a component of the growth rate. In an economy with high demand the requirements for Design Denim's imports will always be high whereas an economy in recession may mean that the demand for products will be low. Consumer demand will inevitably shape the demand Marks and Spencer has for Design Denim's goods.

Social and Technological factors in PEST analysis may not directly affect Design Denim. The social factors such as distributions in age and sex will need to be tackled by Design Denim's customers. Tesco and Marks and Spencer are going to be responsible for bringing the product to the public so they will need to tackle issues in social trends that will shape demand. Design Denim's financial stability may only be at risk if there is a sudden change in for example attitudes to foreign products, meaning the buyer cancels future requirements leaving Design Denim with unsold goods. But this scenario is unlikely as a sudden change in social trends would have to take place within a matter of months. SEDEX

Technological factors will affect Design Denim's suppliers in the short-term as a new process in production could mean efficiency increase that would lead to lower costs, which could be passed on. However a breakthrough by another supplier in technology could leave Design Denim in an uncompetitive position and as discussed previously under Porter's five forces, the buyer may wish to switch suppliers. Nevertheless in terms of shipping the goods to the UK an improvement in transport or logistical technology will be directly beneficial to Design Denim.

2.1 Using LCs in Design Denim

Design Denim is currently banking with Lloyds TSB. Lloyds TSB commercial finance department is extending their import finance facility on a capped basis. Design Denim has negotiated a thirty day credit facility with Lloyds TSB who will initially pay the overseas advising bank. As long as Design Denim does not exceed its limit on the amount agreed between it and the bank, the bank will continue to issue LCs and collect fees and interest on the current balances. The fees are typically composed of sending the documents, checking them for inconsistencies, currency conversion costs and money transfer fees. The interest rate is set at 4% above the bank of England base rate, which is currently 0.5% (Asad Khan). A typical LC for $80,000 would incur fees and interest of £3,000. Such fees are relatively inexpensive compared to having to deal with tens of thousands of pounds of loss if Design Denim were to trade cash up front and the supplier did not deliver.

However the costs of using an LC is relatively low only due to the low base rate. An upward shift in the base rate will increase the cost utilizing an LC (refer to appendix 1). On a typical £50,000 purchase with a 2.0% increase in the base rate, the interest charge would increase by £1,000. This cost would not only harm cash flow, but also would decrease the profitability for Design Denim when it sells its purchased goods on to its customer. Customers such as Tesco usually order in very large quantities but the prices paid are low per unit, meaning margin is small (Asad Khan). Including all other costs associated with buying then selling garments, an increase in interest rates could mean in a worst case scenario that little or no profit is made by Design Denim.

In terms of the LC funds will only be exchanged between the banks if the correct documents have been presented (Trade Finance Guide, 2007). Although the funds will always be secure, with regards to Lloyds TSB's background checking service, the benefit to Design Denim is that the reliability of the advising bank can be seen. Such reliability factors are: whether the documents are presented in good time or good communication between the two banks as examples. This additional protection offered by Lloyds TSB will allow Design Denim to make an informed decision whether to conduct business or switch suppliers.

However in fast moving markets such as the fashion industry the background checking service could be disadvantageous to Design Denim. Rapidly changing markets may require buying from innovative businesses that are newly established. Such new companies may not have a financial history along with their bankers. Lloyds TSB may flag these new companies and reject the LC application as it is seen as too risky for them.

Other than securing funds LCs may be seen as an attractive option compared to borrowing in the terms of a loan to finance purchase. A LC is not disclosed on the company's balance sheet so therefore can make its financial statements look more attractive. However an LC is subject to credit risk if there is a serious failure of the other party to perform according to the contract (FASB 1990, cited in Mooney, 1995). This hidden credit risk may be seen as unethical to investors, but Design Denim is a private limited company and therefore shares cannot be purchased in the company.

Accounting Standards (SFAS) 105 (FASB 1990, par. 7 cited in Mooney, 1995

Using trade credit insurance in Design Denim

Design Denim in the past has delivered goods to a customer who later became bankrupt and failed to both pay for the invoice and to return the goods. This was a relatively small purchase and loss which was absorbed. Design Denim is a recent start-up and lacks vast funds to take a large loss with regards to ordering in bigger lots for Tesco. If Tesco were to go bankrupt while owing Design Denim, they will force Design Denim into bankruptcy also. With the use of trade credit insurance the majority of an approved invoice can be underwritten by a financial institution if the buyer fails to make payment.

Insurance policies require annual premiums to be paid which does have an effect on profits. Design Denim is selling to established companies like Tesco, who are not likely to go bankrupt in the near future. It may be advisable not to pay for trade credit insurance to cover such companies as they are likely to fulfil payment.

Debt factoring for Design Denim

Debt factoring can provide immediate cash injection to be used to pay outstanding bills and creditors. Debt factoring may even be used to fund further purchasing for new orders. 85% of the sales value can be provided on the acceptance of an invoice and customer by the bank. This could be particularly useful to Design Denim as customers usually order a whole range of products to satisfy their departmental needs. With the fees and interest costs it will reduce end profits using this service compared to invoicing and waiting for full payment at a later date. However a small reduction in profit can be outweighed by using the upfront cash offered by the bank to take advantage of new orders.

Strategic Management: Building and Sustaining Competitive Advantage, Fourth Edition. Robert A. Pitts and David Lei. Thompson South-western.

Credit Research Foundation, 1999

Trade Finance Guide. 2007, A Quick Reference for U.S. Exporters The International Trade Administration U.S. Department of Commerce 2007

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Journal of International Accounting Auditing & Taxation, 4(2): 175-I 83 ISSN: 1061-9518

Copyright @ 1995 by JAI Press, Inc. All rights of reproduction in any form reserved.

J. Lowell Mooney l