With the hastening of the process of globalization, we have witnessed an increase in international trade that has stimulated the growth of the world economy as a whole. By trading on an international scale, the traders are exposed to a spectrum of risks including that of payment terms.
Owing to the nature of their roles in the transaction, the importer prefers delaying the payment as much as possible, at least till he receives his goods, and ideally till he resells them. On the other hand, the exporter looks forward to receiving the compensation preferably when the order is placed.
By the end of this article, you will have an insight into what are the five commonly used export payment terms, how do they work, and what are the technicalities attached to them that act as the deciding factors to agree upon one payment term.
This export payment term talks about a method which is deemed as the least secure method for an exporter. Under this method, the exporting party receives its due payment only if the importer is able to sell them in the market to the final customer.
Therefore, the exporter bears all the expenses related to manufacturing and shipping of the goods to the importer, and would also be liable to bear any losses due to probable events like theft, fire, etc. However, the exporter saves on storage costs as they are paid for by the importer.
It is pertinent to note that this method is most suitable when there exists a strong relationship between the two parties in terms of trust and security, there is good demand of the product in the market one is exporting to, and most importantly the goods are insured to provide security against any financial losses.
In this payment term, the exporter initially exports the goods without having received the due payment. The importer is usually liable to pay after an agreed upon date, which is commonly 30, 60, or 90 days after dispatch.
Quite logically, this payment term is preferred by the buyers as it reduces their working capital requirements and operating expenses due to the nature of the transaction which gives them a credit term to sell off the goods in the market. However, exporters are reluctant towards this payment term as they find themselves on the riskier side of the transaction.
An exporter would most likely agree to an open account transaction when wanting to establish good trading relations with a valued buyer, or to not lose the buyer to a competitor.
Last but not the least, to mitigate the risks of losses/nonpayment, exporters use different trade financing options, debt factoring, and insurance.
Documentary Collections (D/C)
In this transaction, the payment part is dealt with by the banks of both the parties. The remitting bank (exporter’s bank) is responsible to send the documents crucial to the transaction e.g., Bill of Lading accompanied by the instruction of payment, to the collecting bank (importer’s bank). Once the collecting bank confirms the authenticity of the documents, the payment is transferred.
This payment term can be subdivided into two payment methods of its own:
Documents Against Payment
Here, the collecting bank is obligated to release the payment to the remitting bank once it has sighted the documents and found them legitimate. This method does not entertain any delay in the transfer of payment.
Documents Against Acceptance
This method dictates the remitting bank to deliver the documents only when there is a solid commitment by the importing party to pay on a specified date, and not immediately.
This term equally distributes the risk between the importer and the exporter. Hence, it can be a good option when the parties are risk averse.
Letter of Credit (L/C)
This is one of the most preferred payment terms by the exporters and commonly used in China and the Middle East countries. Here, the payment procedure is managed by the bank which acts on behalf of the importer. The L/C is provided by the bank which agrees to pay the exporter upon inspection of the documents related to the transaction and satisfaction that they are authentic.
It is important to note that to persuade a bank into giving an L/C, the importer must assure it of its gearing and creditworthiness. The lesser the creditworthiness, the more the fee charged by the bank. Another risk for the importer here is that during the inspection process, the bank will only examine the documents and take no responsibility for the quality of the goods.
On the other hand, the exporter enjoys minimized risk as he is entitled to receive the due payment, nevertheless.
This method is mainly used when the two parties are yet to establish trustworthy trading relations.
Cash In Advance
This is the most desired export payment term in the eyes of the seller whereas the least desired one in the eyes of the buyer. As the name suggests, under this method the importer pays the exporter before the order is dispatched.
Usually, a set percentage of the total compensation is paid prior to the commencement of production. Upon completion, generally the complete amount is cleared before the goods are delivered. However, the parties are also open to agree that any outstanding amount can be paid later. Payment is commonly made using debit cards, wire transfer, or international cheques.
In this transaction, the importing party is at the receiving end of the risks attached as the payment is made up front, way before the goods could be sold in the market.
Due to the high risks attached, this payment method is used rarely. This method is offered when there is a significant level of trust between the two parties.
This method can also be used when the exporting party is offering a commodity that is scarce which makes them less vulnerable to lose the buyer to a competitor. Hence, they cash their strong position.
This transaction is also considered when the size of the order is relatively small.
The risk of payment is a crucial one in an international transaction, and it calls for a decision that is taken after closely scrutinizing the financial needs of oneself as an exporter, depicting how vulnerable one is to the prevalent competition in the market, and researching what are the commonly used payment terms in the industry one is going to deal in. This was export payment terms explained.