There are various risks that have to be considered in International Trade. One of them which involves the seller / exporter is collecting the money for the sales transaction. There are various international trade payment methods which the seller / exporter has to be to be aware of them in order to make the correct decision when the time comes to agree on payment terms with a buyer. The payment term that will be agreed is subject also to how well the seller knows the buyer and how much the buyer can be trusted (which will be covered under trade credit insurance section).
Below we are listing a number of payment terms that can be used in International Trade:
Cash in advance is the most secured payment for the seller / exporter. The seller does not ship the products until he receives the payment from the buyer / importer. Sometimes, when the order involves products that will be produced on demand for the buyer, the seller might request also the payment to be made with the placement of the order. Usually, this is common practice for Chinese manufacturers. They ask for at least 50% payment with the placement of the order and 50% payment prior to loading the products. In some countries were bargain is very popular (i.e. Turkey) the buyer might negotiate to make the payment with the receipt of the order cause this way he can take a % of tax discount. This payment is called cash on delivery but it is very risky for the seller as it does not secure his risk at all.
On the other hand “cash in advance” method is the most risky one for the buyer as he pays the full amount prior to receiving any products.
The Letter of Credit is a more time consuming procedure that contains also the participation of the buyer’s and seller’s banks. The letter of credit is requested from the buyer or the seller when they want to eliminate any risks associated with their trade tactics. It is a form of guaranteeing that the buyer will receive what he was promised and the seller will be paid the amount that they agreed upon. But, there are hidden risks associated with this payment form for both parties and it is important to be aware of the special terminology that escorts the forms of letter of credit in order to make the correct decision.
- Confirmed Letter of Credit: This is the best Letter of Credit option for the seller. When a letter of credit is confirmed by the buyer’s bank the seller is secured 100% even if the buyer or his bank go default. The seller will be paid upon presenting the necessary documents as described in the Confirmed Letter of Credit condition.
- Revocable Letter of Credit: There are cases that although a Letter of Credit is initially confirmed by the buyer’s bank it is also stated as revocable. This means that it can change without necessarily the seller or his bank agreeing on the new terms. This is a condition on a Letter of Credit that the buyer should never accept as it will most probably cause him problems. This type of Letter of Credit is usually made between the two trading parties when they are affiliated or they are subsidiaries etc. and basically trust each other.
- Irrevocable Letter of Credit: This type of Letter of Credit denotes that for any change or cancellation to be made all the parties involved in the business transaction should agree upon. By all parties is meant the Seller and his bank(confirming bank) plus the buyer and his bank(issuing bank). A seller will secure his payment when he will ask for a Confirmed and Irrevocable Letter of Credit.
- Transferable Letter of Credit: This type of Letter of Credit gives the option to the beneficiary party (seller) to request from the buyer’s bank (issuing) or another bank which is authorized by the buyer’s bank, the payment to be made in whole or part to another party or parties.
- Back to Back Letter of Credit: This type of Letter of Letter of Credit is made in order to help the seller finance his business. When the seller for example is not the manufacturer of the cargo that will be sold and he will buy the products on demand from his supplier to sell to the buyer this type of Letter of Credit may allow him to finance the business transaction. The seller will request the Letter of Credit by the Buyer’s bank and when the Letter will be confirmed by his bank he will use it to request issuing another Letter of Credit for his supplier. In this way, even if the seller does not have the fund necessary to buy from his supplier, he can still proceed and make the sale as the second confirmed letter of credit will assure his supplier that he will take his money.
In addition to the Letter of Credit Types mentioned above another differentiation comes from the time the seller can claim his funds. Thus, two types of such agreement may arise:
- Letter of Credit Drawn at Sight: The bank can release the payment as soon as the seller presents all necessary documents as described in the Letter of Credit Condition.
- Time Letter of Credit: The bank will release the payment after receiving the necessary documents but also after the days stated in the Letter of Credit condition pass. This type of Letter of Credit is used when the seller wants to secure his payment but is willing also to help the buyer by giving him a form of a credit agreement.
To be noted that when the Letter of Credit is Drawn at Sight the buyer is not guaranteeing that he will pay after receiving the products that he ordered. The payment may be released by the bank to the seller upon only a presentation of the necessary documents. In order for the buyer to also eliminate all risks the key is in the documents that will be requested on the Letter of Credit. If the buyer wants to eliminate all risk he should also ask for a certificate of inspection document. In this case a third party assigned by the agreement will be authorized to inspect the cargo either at the place of loading or the place of delivery. If in either case the products do not comply with the agreement then the buyer can reject sending the funds.
One would assume that by requesting a Time Letter of Credit the seller can be 100% sure that he will receive what he ordered and then release the funds. But this is not true. With the Time Letter of Credit the seller can receive the funds even prior to the deadline mentioned in the agreement. He can request them from the bank as a form of loan and the bank will give it to him as it is sure that she will receive the amount. The bank in this case will charge him some loan interest rates until the moment the date specified in the Letter of Credit Agreement arises. Even if the buyer realizes that the products that he received are not what he ordered he does not have the right to stop the payment procedure. Thus, it is important to note that independent inspection companies can provide the services that are needed in order for the buyer to be also secured and this is something that has to be added in the Letter of Credit agreement.
This type of payment method is similar to a check issued by a local buyer with the same risks involved (the check could bounce). This type of payment method is less complex than the Letter of Credit and the banks charge less fees as well. The seller and buyer plus their banks participate in the process but the banks in this case do not guarantee the payment but are just responsible in following the flow of documents. The importer sends the purchase order to the exporter and the second prepares the order and ships the cargo. While the products are on transit the forwarder presents the documents to his bank and his bank contacts the importer’s bank to request for the payment as requested by the exporter. If the payment is not made the importer cannot release the cargo at destination. But if the buyer cannot pay for the cargo the cargo still belongs to the exporter and the second has to find a way to sell the cargo to another customer or to send it back to his warehouse. This option is not safe for the exporter and should not be used unless the two parties have long time business relationship and can trust each other. On the other hand the importer cannot be 100% sure that he will pay for the products he agreed to receive unless he authorizes a third party inspection company to make inspection on the cargo prior to releasing the Bill of Exchange Payment.
The Open Account method of payment is risky for the exporter. This is because the exporter prepares and ships his goods prior to receiving any payment and any guarantee that the payment will be made by the importer. In this case the trade agreement is based only on trust. As it is easily understood this type of payment method is agreed usually between traders that have a long lasting business relationship and trust each other. In case a trade agreement is made based on Open Account and the importer does not pay the exporter, it is very difficult, expensive and time consuming for the exporter to receive the payment.
Consignment is the most risky method of payment for the exporter and the best one for the importer. In this type of payment the exporter agrees to send the products to the importer and be paid for them not with the delivery but when the products are sold. The exporter possesses the products even when they are stored on the importers warehouse. Only when the products are sold and the importer has received the payment for the sale, the exporter can receive his portion of the value of the products.
This type of payment method is not used so often but in some occasions (i.e. old fashioned products, or products that were produced by mistake and the exporter cannot sell in his market etc.) it can be a type of solution for the exporter in order not to write off completely the value of the products from his books.
For more detailed info about the International Payment Methods and Finance in general you may consult one of the below books (First or Second Edition). They contain a valuable list of information.