A seller is most concerned about being paid on time and in full. There are several components to structuring the sales contract that must be considered including the payment method and sales term. The payment method reflects the seller/buyer relationship and cash flow impact to both parties; and the sales term affects the pricing. A lack of understanding of both can have a negative impact, particularly to the seller.
International Payment Methods
When negotiating the payment method, it is important that the payment method risk is understood by both parties, i.e. put oneself in the other’s shoes.
The payment method used is also a function of your risk profile, which includes: overall tolerance for risk, relationship with your buyer, impact on cash flow, competition and the effect of non-payment on your business.
There are four primary payment methods used in international transactions. Ranked from least to riskiest from the seller’s perspective, they are:
Payment in Advance
The seller has the funds before the product is shipped. Virtually all risk is with buyer. The buyer will usually agree to this term when they are desperate for the product. Since the seller has received funds before any production or shipment has taken place, the cash flow benefit is exclusively with the seller. The only risk to the seller is that the sales opportunity is limited.
Letter of Credit
A letter of credit (LC) is a commitment made by a bank to pay on behalf of a buyer. The fact that a bank is willing to provide a LC indicates a level of credit worthiness that can give comfort to the seller. Should the seller comply with the terms and conditions of the LC, payment is assured from either the buyer or, if the buyer cannot pay, by the bank that issued the LC. And the buyer is given comfort that the goods shipped are those agreed to within the sales contract.
Terms and conditions include shipping documents, packing list, latest shipping date, ports of debarkation and embarkation and Incoterm (see more on Incoterm below).
The seller should work with their bank to provide guidance to the buyer as to expected terms and conditions of the LC. A draft of the LC should be reviewed by the seller to assure their ability to comply with the terms and conditions. Once issued, the LC can be amended with the agreement by both parties, but fees are assessed by the banks for amendments.
How it works:
- LC is issued by the buyer’s bank which sends it to the seller’s bank.
- Seller’s bank “advises” the seller that the LC has been received and the LC is sent to the seller.
- Seller reviews the LC’s terms and conditions and sends a copy to its freight forwarder.
- Seller and freight forwarder prepares the shipment per the terms and conditions.
- Upon shipment and receipt of shipping documents, all required documentation is submitted to the seller’s bank for review to determine compliance with the LC.
- If in compliance, documents are sent by the seller’s bank to the buyer’s bank for a similar compliance review
- Upon the buyer’s bank review resulting in compliance to the LC, the buyer’s bank debits the buyer’s account for the payment amount and wires the funds to the seller. The documents are released to the buyer.
Compliance of a LC can be difficult for a seller and the buyer’s credit line with a bank is impacted by the issuance of an LC. The seller can consider the documentary collection versus the LC payment method as a means to maintaining control of the shipping documents within the banking system without having the banks’ review of the documents.
How it works:
- Seller submits the shipping documents to the seller’s bank.
- Seller’s bank prepares a cover letter itemizing the documents and sends the cover letter and documents to the buyer’s bank.
- Buyer’s bank contacts the buyer upon receipt of documents and asks if buyer wants to pay for the documents?
- If yes, the buyer’s account is debited for the payment and funds are wired to the seller. Documents are released to the buyer
- If no, documents are returned to the seller.
- Seller’s risk is, although title to goods is maintained, the goods are in the buyer’s port
- Options are negotiating a new price with the buyer or finding a new buyer
Open account terms represent the highest risk of non-payment for the seller. The product has been shipped and the buyer is to pay sometime after the shipment. This term should be used only when the seller/buyer relationship is deemed strong by the seller. The cash flow impact to the seller is very adverse as all the costs of production and shipment have been incurred before any sales revenue has been received. To mitigate the non-payment risk, the seller should consider insuring the buyer by obtaining a credit insurance policy.
Credit insurance is beneficial for the seller in two ways:
- A competitive sales tool for safely extending credit.
- The creation of collateral should the seller wish to obtain financing for the foreign account receivable. This is accomplished by the transfer of the loss payee on the policy from the seller to the bank providing the financing.
Export credit insurance policies are offered by private carriers as well as by the Export Import Bank of the U.S. (Ex-Im). Ex-Im is a good place to start to learn about credit insurance. Contact your local Ex-Im trade finance specialist at http://grow.exim.gov/.
Sales (INCOTERMS) Terms
All costs of a sales transaction need to be captured including the cost of goods sold and costs associated with the shipment of the product to the international buyer. Such costs include freight forwarder fees, freight and insurance. Capture of all costs will help determine the sales price that reflects the profit margin that the seller wishes to achieve.
INCOTERMs are published by the International Chamber of Commerce and are intended to define the costs (including freight and insurance) involved in the shipment of product from the seller to the buyer AND to define when the freight and insurance responsibilities transfer from the seller to the buyer. The INCOTERMs do not represent when there is a transfer of ownership.
It is important to understand and use INCOTERMS correctly. A simple misunderstanding may prevent the seller from meeting contractual obligations or make the seller responsible for shipping costs you sought to avoid. Misunderstanding can be minimized by:
- specifying the INCOTERM and the named point of transfer (e.g. CIF-Seattle) of risks and costs
- and enlisting a freight forwarder to provide counsel and assistance.
INCOTERMS can be found here: Defined terms in Incoterms
Financing the Export Sale
As previously mentioned, the payment methods used have impacts on the cash flow of the business. From the seller’s perspective, the riskier the payment method, the more adverse the cash flow impact.
Can the business’s working capital alone support the payment methods used, or does the business need financing assistance to support the export sales? Proper financing is an integral part of a business plan. To help develop your export plan, do one of two things:
- Check out the SBA Export Business Planner: https://www.sba.gov/sites/default/files/SBA%20Export%20Business%20Planner.pdf
- Meet with a counselor from your local Small Business Development Center: http://wsbdc.org/services/exports/
With a plan in place and if bank financing makes sense, by all means talk to your bank. If your bank is unfamiliar with export finance, you should find a bank that can help you. The SBDC counselor can refer you to the appropriate banks.
Such banks can structure financing packages that take into consideration the international elements of your supply chain including pre- and post-shipment financing, utilization of credit insurance, as well as the purchase of machinery and other fixed assets associated with the development of export sales.
The U.S. Small Business Administration offers export finance guaranty programs that encourage banks to provide export finance for working capital and fixed assets.
About the Author
Doug Kemper is the Director of International Banking Services for Washington Trust Bank. He is responsible for all things international including payment products, trade finance, relationship manager training, external marketing and correspondent bank relationships.
Immediately prior to his present position, he was the President and CEO of the non-profit Export Finance Assistance Center of Washington which provided export finance counsel to SMEs and community banks in the State of Washington.
Doug has many years of commercial banking and trade finance experience with regional and community banks. He commenced his financial services career as a US Treasury Department/OCC National Bank Examiner based in Seattle and London.
He is a graduate of both Oregon State University with a BS degree in International Business and the Pacific Coast Banking School. He is an Advisory Board member of Oregon State University’s MBA Global Operations (Supply Chain) track.