A crucial part of any transaction is ensuring you get paid. Different payment methods, and the risks involved whether you are an importer or exporter, are explained in this section.
The Risk Ladder
International trade can seem a complex activity with a long order-to-cash transaction cycle. The key to successful international trade is understanding and managing the risks you face. For importers and exporters, the amount of risk involved in a transaction fluctuates depending on what payment method you use.
As an importer, you want to ensure you receive the goods you’ve ordered. The most common option for importers is open account trading, as it poses the least risk, ensuring you receive the goods before paying for them.
For those exporting, cash in advance is always the least risky option, where you receive payment before shipping the goods. In this case, the importer is essentially funding your working capital and leaves no payment risk to you.
In an ideal world, exporters would get paid for their goods at the moment when the importer takes possession of them. Conversely, an importer should not expect to have to part with money before he has the goods to show for it. At the start of a business relationship (and even later, if there is some element of risk involved) an exporter may request advance payment. The importer may well agree to it in order to encourage the exporter to build an established relationship. In advance payment, all the advantages accrue to the exporter, and all the disadvantages accrue to the importer, who has parted with his money and has no assurance of receiving the goods. More usually, some element of credit will be involved.
Open account trading
The exporter despatches goods to the importer and at the same time sends an invoice for those goods, for payment at an agreed date or after an agreed period. Open account trading is a common payment method used for trade between established pairs of exporters and importers, both of whom operate in stable markets such as Western Europe or the USA.
The advantages all accrue to the importer. The disadvantages all accrue to the exporter. If the customer does not pay, or if he does pay but his country blocks remittance of funds to the exporter, the exporter has neither the goods nor the money, and the exporter may not be able to get his goods back.
Collections do not give the exporter the security of advance payment, or the relative peace of mind that comes from open account transactions with long-term customers in established relationships. They require both exporter and importer to exercise great care in agreeing the detail of the sales contract. The transaction is initiated by the exporter, who despatches the goods to the importer’s country. At the same time, he entrusts the related documents (which may include negotiable Bills of Lading) to his bank, for collection of sale proceeds and the delivery of documents to the importer according to the terms of the sales contract.
There are three types of collection:
• clean collection
• documentary collection: documents against acceptance (D/A)
• documentary collection: documents against payment (D/P).
For a clean collection, the exporter despatches the goods and the related documents directly to the importer and then sends his bank the bill of exchange for the value of the goods drawn according to the sales contract, so that his bank can begin to collect the due amount from the importer. All the advantages lie with the importer and against the exporter. If the importer does not pay, or if he does pay but his country blocks remittance of funds to the exporter, the exporter has neither the goods nor the money, and he may not get his goods back.
For a documentary collection D/A, the exporter does not authorise release of the transport documents (needed to obtain delivery of the goods) until the importer accepts the bill of exchange for payment at a definite future date. Once the importer accepts the bill of exchange, the importer’s bank releases the transport documents needed to obtain delivery of the goods and any other remaining documents. The importer can then take possession of the goods for which he has agreed to pay in terms of the accepted bill at a definite date in the future. Again, all the advantages lie with the importer and against the exporter. If the importer does not pay on the due date, or if he does pay but his country blocks remittance of funds to the exporter, the exporter has neither the goods nor the money, and he may not get his goods back.
Depending on the nature of transport and the terms of the collection, even this level of control may not be readily available (e.g. where Air Waybills are used).
The essential word in documentary collection D/P collections is “payment”. There are two types of D/P collection – D/P with payment at sight and D/P with payment at an agreed period after sight. The two differ according to when payment is made, but in both types the documents that give title to the goods are released to the importer only upon payment. Unlike collections on D/A terms, collections on D/P terms can leave the exporter in effective control of the goods until payment, where the nature of transport and collection order permit.
Documentary Letters of Credit
Documentary Letters of Credit, or as they are more commonly referred to as Letters of Credit (L/C), can help minimise risk. With other payment methods (advance payments, open account trading and collections) the exporter and the importer each depend on the other for proper performance in order to ensure a trouble-free exchange of goods for payment. In Documentary Letters of Credit, however, the exporter and the importer both have the additional independent assurance of the bank that issues the L/C (the Issuing Bank).
In issuing a L/C in favour of an exporter (or “beneficiary” – the exporter is the beneficiary of any L/C discussed here) an Issuing Bank undertakes to pay the exporter, provided that:
• the documents stipulated in the L/C are in order, and
• the terms and conditions of the L/C are complied with
An importer (as the applicant for the L/C issued by his bank) has the assurance that his bank will ensure that all the documents he specifies (including any transport and insurance documents stipulated in the L/C) are received in order and that all the terms and conditions of the L/C are complied with before any payment is made to the exporter.
The advantages are shared by the exporter and importer: both have independent assurance that goods and money will be exchanged according to the terms of the sales contract, as long as the terms of the Letter of Credit reflect the sales contract. However, the exporter is still at some risk of non-payment. If the exporter is unable to meet terms and conditions of the L/C, there is no guarantee of payment, even if the goods have already been shipped. If the Issuing Bank finds discrepancies not previously found by either the exporter or the Paying Bank, there is also no guarantee of payment. Only in the case of a confirmed L/C does the exporter have the additional assurance of payment by a second bank (the Confirming Bank).
Additional methods: Credit Insurance
Credit Insurance mainly covers the following risks to an exporter:
• non-acceptance of the goods by the importer
• insolvency of the importer
• unacceptable delays by the importer in effecting payment (e.g. delays of over six months from due date for payment of goods accepted by the importer)
• blocking of the transfer of payments made by importer
• inability to convert local currency payments into the required foreign currency
• wars and civil disturbances outside the UK that prevent completion of the sale.
Insurers offer a variety of services, combining trade finance facilities and Credit Insurance. Information is provided on existing and potential buyers and on political and economic conditions, together with short and long-term forecasts. Terms and conditions vary from policy to policy, but an exporter’s individual requirements will be accommodated wherever possible. The terms of most policies would require the exporter to comply with specific provisions, varying from the observance of agreed buyer limits and margins to the need for insisting on protest action in the event of the importer’s non-acceptance or non-payment.
Credit Insurance benefits the exporter by allowing him to price competitively while still pursuing business in areas where there may be a high risk of non-payment. The cost of Credit Insurance should be weighed against the risk of complete loss on the whole transaction. There are other incidental benefits for the exporter, some of which are as follows:
• importers are keen to avoid being known as defaulters in international markets, since default will be noted by the exporter’s insurers and possibly be made known to other insurers too
• so far as bankers and suppliers are concerned, the exporter’s Credit rating may be improved.