Does your CFO groan when you discuss international sales? Does your accounts receivable aging report look like a study in xenophobia?
International sales can mean delayed payment and can carry its own payment security risks. It’s certainly easier to collect in Toronto than in Tokyo, or in New York than Nigeria. International collections usually involve increased delays, administrative burden, legal costs and additional complexity.
So how does one provide payment security for international sales and improve cash flow?
Understanding the payment security spectrum
Let us first review the range of one’s payment security options. The first, “open account”, is most favorable to the buyer and least favorable to the seller. On the other end of the spectrum is “payment in advance”, which is least favorable to the buyer and most favorable to the seller. Here are all five options across the spectrum:
- Open Account
- Documentary Collections (Documentary Draft – The Reverse Check)
- Letters of Credit
- Confirmed Letters of Credit
- Payment in Advance – Inclusive of Partial Payment in Advance
You may find the ends of this spectrum to be hard to pitch to either the seller or buyer. With new or unproven customers, the seller will be hesitant to ship goods on open account, with no guarantee of payment. On the other end of the spectrum, few customers are willing to prepay and trust a vendor to ship goods, with no guarantee of shipment.
Note one exception, however. Partial pre-payment (or progress payments) are standard in certain industries. For example, construction companies or large equipment companies may require progress payments at certain stages of a project (e.g., a percentage payment upon issuance of a purchaser order, a further percentage payment upon approved drawings, a percentage payment upon purchase of major materials, etc.).
If you are not in an industry that routinely relies on pre-payment, avoid the extremes of sales on open account vs. prepayment by utilizing a documentary draft or a letter of credit.
Here’s why the documentary draft usually works well for both buyers and sellers
The documentary draft (or bill of exchange, as it may be called) is a special type of negotiable instrument, like a reverse check, that is commonly used to expedite payment. It provides the seller with the security of not permitting the buyer to possess the goods until the draft is paid, or is authorized to be paid.
Moreover, in the event of the buyer’s failure to pay, it permits a seller or the international bank involved in the transaction to sue the buyer, based on the draft alone, without having to prove the terms of the underlying sales contract.
How does the draft work? The seller ships goods, generates appropriate documents (e.g., commercial invoice, certificate of origin, etc.) and also receives documentation from the shipper (e.g., bill of lading).
We will collectively refer to these documents hereafter as the “title documents”. The title documents are then forwarded to the remitting bank (the seller’s bank), which in turn forwards the title documents to the collecting/presenting bank (usually the buyer’s bank).
The collecting/presenting bank compares the title documents to the draft’s requirements. If the documentation is in order, payment may be authorized and the title documents are released to the buyer. With the Title Documents in hand, the buyer can then retrieve the goods.
This is a relatively simple and inexpensive payment method. It often provides for more prompt payment than an open account, and the seller has the security of retaining title to the goods until payment is authorized by the buyer.
While this method is more secure than an open account transaction, there is still some risk that the buyer may reject the documents or otherwise renege on the transaction. The banks do not guarantee payment of the draft.
If all else fails, a letter of credit may be better for securing payment
If a seller is unwilling to risk the customer’s potential refusal to honor a documentary draft, they may prefer that a letter of credit is used to secure payment. In this manner, the buyer’s bank guarantees payment and the buyer hasn’t the discretion to reject payment. In this case, the seller must transmit title documents (as defined above) that satisfy the conditions of the letter of credit.
The letter of credit transaction begins with the seller and buyer agreeing to a letter of credit format and terms. For instance, the buyer might call for the letter of credit to require that the bill of lading be negotiable or marked “freight prepaid,” or that the packing slip or certificate of analysis contain certifications as to quality, weight or markings.
The buyer will then request its bank (the issuing bank) to issue the letter of credit in favor of the seller. The letter of credit is forwarded to a bank nearer to the seller’s place of business, and this bank (the advising bank) notifies the seller of its receipt of the letter of credit.
Presuming the seller ships goods prior to the letter of credit’s expiration date, the seller generates and obtains the title documents (e.g., commercial invoice, bill of lading, etc.).
These title documents are then forwarded to the issuing bank, which will effectuate payment in the event the documents meet all requirements of the letter of credit. The issuing bank will release the title documents to the buyer, who can then claim the goods.
Similar to documentary drafts, letters of credit may be “sight” letters of credit, where payment is effectuated promptly upon the issuing bank’s acceptance of the required title documents, or “time” letters of credit, which provide for payment some period after acceptance of that documentation.
For an additional charge, the seller may overcome concerns that the foreign issuing bank may not honor the letter of credit, whether for unscrupulous reasons or due to financial solvency issues. This is done by paying for the letter of credit to be “confirmed.” Generally, the seller pays its own bank to confirm (that is, guarantee) payment in the event the issuing bank fails to do so.
When using them, ensure that letter of credit costs (including confirming costs, if applicable) are included at the bid stage so your margins are not later decreased by this amount. Use only reputable banks. Insist upon an irrevocable letter of credit rather than one that is revocable. Ensure that the documents you forward to the issuing bank strictly comply with letter of credit requirements – failing to do so may result in late payment or, in the event of a delay beyond the letter of credit expiration date, possible non-payment. Become generally familiar with the Uniform Customs and Practice for Documentary Credits to understand the rules of the issuance and use of letters of credit.
If you want to expedite international payments and be more assured of payment, use the documentary draft or letter of credit. Your CFO will love you for it.