International trade is a very complex process as it poses certain risks to both the importers and exporters. Due to the complicated nature of international trade, settlement of payment is also a very tricky issue. The importers want to receive goods before making payment. Conversely, the exporters desire to get the full payment before delivering the goods. Hence, it becomes very important to find suitable payment methods that favor both the parties, i.e. importer and exporter.
The following five types of payment methods are in vogue in international trade:
1. Cash in Advance or Advance Payment
In this method, the importer pays for the goods upfront and before receipt of the consignment. The payment may be transferred by any means, such as wire transfer, international cheque, or credit card.
This payment term is most favorable for the exporter because they receive payment before goods are shipped. For the importers, this is the least desirable method because they have the risk of shipment not being received or received with delay.
Moreover, this method is also not favorable for the business cash flow of the importers because they have to pay for the goods upfront.
2. Open account
In this method, the exporter agrees to deliver goods to the importer before receiving payment. Payment normally falls due after an agreed time period, say 60, 90, or 120 days after delivery of goods. This payment method is in fact the opposite of the advance payment method.
This method is most favorable for the importer as he receives goods before making payment. For the exporter, this is the least desirable payment method because he runs the risk of not receiving payment at all or late payment.
Moreover, the exporter may face cash flow constraints as his funds are tied up and he is left with a lesser amount of working capital.
3. Documentary Credit or Letter of Credit (L/C)
This is the most well-known payment method in international trade and is also one of the most secure payment methods. A letter of credit is a promise by a bank to pay the exporter if all terms of the contract [between importer and exporter] are fulfilled properly. These terms & conditions are typically included in the L/C itself.
The following steps are generally involved in L/C transaction:-
- Importer applies for L/C with his bank
- L/C is established by the bank (called Issuing Bank) and the same is conveyed to the Exporter’s bank and the exporter
- The exporter ships the goods and submits title documents (complying with L/C terms) to his bank.
- The exporter’s bank then sends these documents to the Importer’s bank
- The importer’s bank (L/C issuing bank) scrutinizes the documents and hands these over to the Importer against receipt of payment or acceptance.
- Importer’s bank transmits payment to Exporter’s bank
- Importer gets possession of the goods against these documents
4. Documentary Collections
In this method, the exporter asks his bank to forward shipping documents pertaining to the sale of goods/shipment to the importer’s bank, with a request to present the documents to the importer specifying the conditions as to how these documents can be released to the buyer. In other words, the exporter’s bank forwards documents to the importer’s bank and collects payment of shipped goods.
In documentary collections, banks only serve as channels for forwarding documents and do not guarantee any payments.
The process of documentary collection involves the following steps:
- Exporter ships the goods and submits the documents of title to goods to his bank
- The exporter’s bank (Remitting bank) dispatches these documents to the importer’s bank
- The importer’s bank (collecting bank) receives documents and informs the importer
- The importer either makes payment or accepts the time draft and gets the documents released to collect the goods.
There are 2 methods within this payment term depending upon when payment is made to the exporter:
1. Documents Against Payment (DAP)
In this arrangement, the bank releases documents to the importer only after receiving the payment. The importer is required to pay the face value before shipping documents are released to him.
2. Documents Against Acceptance (DA)
In this arrangement, documents are delivered to the importer’s bank upon receipt of a firm commitment from the importer to pay on a specified date. Here payment is not received immediately but on a future date mutually agreed upon between the importer and exporter. The importer accepts the draft / Bill of Exchange and the bank releases documents to him.
5. Consignment Method
In this method, the exporter delivers the goods to the importer, but payment is received only after the goods are sold. Though the goods are in possession of the importer, the ownership remains with the exporter until these are sold.
This payment term is normally used by those exporters who have their own distributors or agents in foreign countries.
This method also poses serious risks to the exporter because he bears all the costs of manufacturing, shipping, and delivering goods to the importer while the risk of non-payment or late payment by the importer is always there.