There are five major payment methods you will often see parties adopting in international trade. These are cash in advance, letter of credit, documentary collections, open account, and consignment. We will discuss each of these below.
1. Cash in advance
Also called ‘advance payment’ or ‘cash with order’, cash in advance means exactly what it sounds like. It is a mostly straightforward payment method where the importer (usually the buyer) pays for the goods upfront and before shipment. The payment may be completed by any means agreed between the exporter and the importer. Popular options include wire transfer, international cheque, and payment by debit card.
This payment term clearly favors the exporter because it means they receive payment while still in possession of the goods. A typical procedure for parties using this method is to agree that a set percentage of the price will be paid before production starts. After production, either all or most of the outstanding price will be paid before shipment. They may then agree that any amounts left will be paid upon receipt of the goods by the importer.
Cash in advance presents a lot of risk for the importer. This is because it puts them in a position where the exporter still has ownership and possession of the goods and has already received payment for the goods. It also creates an unfavorable cash flow situation for the importer because they have to pay all of the price upfronts and in cash – a position most buyers try to avoid.
Obviously, this payment option will only be available in rare situations. This can include where the order size is very small, or situations where the exporter is in a very strong negotiating position (such as where the goods are scarce). It can also be an option for exporters who are not convinced of the importer’s credit-worthiness, or where the importer completely trusts the seller.
As a result, exporters will very rarely offer this payment term because it presents so much risk for the buyer. If you want to attract more sales or a higher caliber of buyers, you will need to be more flexible with your payment terms, except where the special circumstances mentioned above exist.
2. Letter of credit (L/C)
Letter of credit is one of the most well-known terms of payment in international trade. It is also one of the most secure payment methods available2. This payment method is quite popular in the Middle East and China. It involves a payment process that is conducted by a bank on behalf of the importer. The letter of credit is a document that operates as a guarantee by the bank saying it will pay the exporter for the goods once certain terms and conditions are fulfilled. These terms and conditions are typically included in the letter of credit itself, and mostly have to do with inspecting the documents accompanying the goods, rather than the goods themselves.
Before an importer can obtain a letter of credit, they must be able to satisfy their bank of their credit-worthiness. When the bank completes the payment on behalf of the importer, they will turn towards the importer for reimbursement. This is usually based on terms agreed between the importer and the bank.
Letters of credit are mostly applicable in situations where the exporter and importer have a new and untested trade relationship. They can also be a good option where the exporter is not satisfied with the credit-worthiness of the importer or is unable to confirm this. Either way, a letter of credit provides less risk for the exporter since they have a solid guarantee of payment.
This payment term has its disadvantages though. For one, it is generally considered to be very expensive, as the banks involved will typically charge significant fees. The fees will vary depending on the importer’s credit rating and the complexity of the transaction. Also, the bank does not generally inspect the goods shipped by the exporter. This means there may be no provision to establish the quality of the goods in the process.
3. Documentary collections (D/C)
Documentary collection is a very balanced payment term that provides almost equal risk exposure for exporter and importer. This method is completed exclusively between banks acting on behalf of both parties. The process starts when the exporter ships the goods and sends documents needed to claim the goods to the importer. These documents usually include the Bill of Lading.
The importer also lodges payment with their bank with the instruction that payment should be made upon confirmation of the documents. Once the documents are confirmed, the documents will be released to the importer, enabling him to claim the documents. In this way, documentary collections work almost like escrow (which lets you lodge payment with a third party pending the completion of the agreement)3.
There are two major methods within this payment term. They are documents against payment (DAP) and documents against acceptance (DA).
Documents against payment (DAP): Here, the agreement is that the bank will release payment to the exporter upon sighting the documents. No delay in payment is expected here, and once the documents are shown (and found regular), payment must be completed.
Documents against acceptance (DA): Here, the agreement is that the documents will be delivered to the importer’s bank once there is a firm commitment to pay on a fixed date. This means payment is not received immediately, but on a date agreed between the parties.
Since this payment method is relatively balanced, it does not expose either party to too much risk. The seller only lets go of ownership and possession of the goods once payment or a firm commitment to pay is received. The buyer only pays when they see the documents for the goods, or even after taking physical delivery. This method also involves less cost overall than letter of credit, and it can be set up in less time.
However, just like letter of credit, the focus of both banks is on documents, and not necessarily the goods themselves. This means it may be harder to discover a problem with the quality of the goods before payment is made. The payment method also provides very little recourse for the exporter in the event that the importer fails to pay for the goods. Apart from these, documentary collections present a balanced payment method for both exporter and importer.
4. Open account (O/A)
This payment term involves a trade deal where the exporter agrees to deliver the goods to the importer without receiving payment until a later date. Payment usually falls due after an agreed period, typically 30, 60, or 90 days after delivery. Therefore, the importer essentially receives the goods on credit, with payment to follow at a later date.
Clearly, this payment method favors the importer, since they enjoy the position of taking delivery of the goods without making payment. It can have the effect of reducing their operating expenses, seeing as they can simply order the goods and try to sell completely before they have to pay the exporter. It also reduces their need for working capital, as they don’t have to worry about freeing up funds to complete payment before taking delivery of the goods.
Due to these advantages, importers are always keen to find exporters that provide open account payment terms. In a buyers’ market (one where there are more goods and less demand), you may see open account terms being the dominant mode of payment. Exporters that also want to display trust in a valued customer or that want to attract a valuable account may be more willing to offer these terms.
However, you should keep in mind that open account is also very risky for exporters. The risks of non-payment, late payment, bankruptcy, and other unexpected events are very high in this transaction. In addition, exporters essentially have to produce the goods and ship them without receiving payment. This can leave them with less working capital than they would like. Overall, this payment term has the potential to put exporters in a very delicate position.
For these reasons, it is very common to see exporters try to protect their position by exploring trade finance options. These are essentially mechanisms that help the exporter protect themselves against loss, pending when they receive full payment from the importer. Popular options exporters can explore include export credit insurance4 and factoring5.
You should only explore this option in situations where you have a low-risk trading relationship with the importer. Another possibility is where there is very low demand or where you are looking to win important customers.
5. Consignment
The final major payment term you should know about is consignment. Here, the exporter produces, ships, and delivers the goods to the buyer but only collects payment after the goods have been sold. You can often see this payment term being used by exporters who have distributors or third-party agents in foreign countries. Perhaps it may be rarer to find this situation in normal seller-buyer relationships.
The rarity of this payment term is based on a simple reason – the incredible risk it poses to exporters. The exporter bears all of the costs of producing, shipping, and delivering the goods to the importer. In addition, while the goods are in possession of the importer, they typically continue to be the property of the exporter. This means where there is an event like fire, theft, storm, or other damage, it is the exporter that bears the loss.
The exporter also bears the risk of non-payment or late payment by the importer. This is in addition to the risk that the goods may not even sell as well as the parties had hoped. As a result, exporters are understandably reluctant to offer or accept these terms from buyers.
The payment term is most applicable where there is an existing relationship between the exporter and importer. The importer needs to be reputable and trustworthy, and the goods must have been shipped to a country that is politically and commercially secure. In addition, this payment term simply cannot be accomplished without putting in place proper insurance measures and taking advantage of trade financing options6 where available.
Where the exporter is able to protect themselves well, consignment can also deliver advantages for them. It can be a good opportunity for exporters to enter new markets, reduce the costs of maintaining inventory (thereby allowing for lower prices), or simply make goods available much faster (leading to competitive advantages).
Other financial terms you should know about
Apart from the major payment terms, there are a few other terms that have evolved over the years. Here are a couple of terms you should know about:
Bank payment obligation: This is one of the newer payment terms being offered in modern times. The process involves two banks – an obligor bank that acts on behalf of the importer, and a recipient bank acting on behalf of the exporter. The obligor bank signs an irrevocable undertaking to pay the price of the goods to the recipient bank on an agreed date. The payment is made once there is a successful matching of electronic data relating to the trade deal.
Confirmed letter of credit: This is essentially a letter of credit, but with an important difference. Here, the letter of credit issued by the importer’s bank is confirmed by another bank of the exporter’s choice. The confirmation is more than just checking to see if the importer’s bank is solvent and capable of paying. The exporter’s bank also agrees to pay the exporter if the importer’s bank fails to pay.
SOURCE: https://seller.alibaba.com/businessblogs/pxkp76iz?tracelog=ggsedm_blog_all&to=cesarppereira%40tothbr.com&node=&biz_type=&crm_mtn_tracelog_template=2002007627&crm_mtn_tracelog_task_id=1038d3e1-1806-4634-9a85-26abf79f0f21&crm_mtn_tracelog_from_sys=service_wolf-web&crm_mtn_tracelog_log_id=25781518296&from=globalsupplier%40service.alibaba.com
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