Methods of Payment in International Trade Finance Essay

Trade is the exchange of goods, services, currencies or intellectual properties. International trade is the exchange of goods, services, currencies and intellectual properties among different countries. There had been many limitations on the trade previous eras, but now these restrictions are mostly eliminated. Although these eliminations, international trade is still regulated and conducted by governments and usually has the burden of tariffs. These tax tariffs or different regulation policies may cause some problems which is called trade barriers. In order to make international trade efficiently, importers and exporters use different payment methods. Since the tariffs and different credit risk levels cause problems, different payment methods are needed. There are five methods of payment in international trade which are open account method, cash in advance method, documents against payment method, documents against acceptance method and letter of credit or documentary credit. In all these methods the aim is to even both parties and create equilibrium. The less creditworthy party always takes the risk in transactions. If both parties are evenly creditworthy, then an even agreement is performed. Below the methods are listed from the most risk to least risk for the exporter and shown in a table to give a brief idea.

Open Account Method

In this method exporter takes the risk and delivers the entities first. After the delivery importer makes the payment. In detail, when the exporter company performs the delivery an invoice is made by it. With this invoice the payment is asked within certain days which can differ from 15 to 90 days. This process is shown as invoice + (15… 90). Since this method carries the risk for Exporter Company, it is not preferred by sellers. However, when the importer is a very strong famous company, it can only accept business transactions with this method, so this method can be the only way for trade. If there is a difference in terms of credibility level of importer and exporter and exporter is the inferior part in the transaction, then this method is convenient. Indeed open account is the most preferred method among international trade payment methods. When implementing this method exporter should measure the credit risk level of both the importer company and the country of the importer company.

Documents against payment

In this method the importer company makes the payment to a bank in the exporter company's country. After payment the documents are sent to Exporter Company, so it is assured about the payment. After this guarantee, Exporter Company ships the entities to importer and when Importer Company gets the entities, it informs the bank about it. In the end bank makes the payment to Exporter Company. This payment method is useful when the importer wants to be sure of the deliverance before payment, and it is less risky than documents against payment method in terms of exporters.

Documents against acceptance

In this method the exporters gives the bill of lading to the banks in importers' nation state. These banks pass the document to importers, so they are assured of the shipment. Afterwards, importers make the payment and inform the bank about it. In the end goods are delivered to importers. This payment term is mostly risky for the exporters but not as much risky as open account method. To summarize, in open account and documents against acceptance methods exporters take more risk than importers whereas in documents against payment method most of the risk carried by importers.

Documentary credit or letter of credit

Documentary credit or letter of credit is an agreement which equals the risk of the importers and exporters. This equalization is provided with the involvement of other parties (banks). The biggest pro of this method is the equal levels of risk but there are some cons like baking fees, bureaucracy and lots of documentation problems. Both the importer and the exporter should be very careful about the contract since it can be canceled just because of a single spelling mistake. These contracts should be mirror imaged, fully identical since they are under the rule of strict compliance. Letter of credit can be convenient if the importer and the exporter do not know each other so well and not sure about the other party's creditworthiness. Otherwise, it is not so convenient to se letter of credit because of the high charges of the banks and bureaucratic issues. The process of letter of credit is complicated and can be summarized as; when the contract of letter of credit is signed Importer Company applies to a bank in its country which is the issuer bank. This issuing bank prepares a letter of credit and delivers it to an advising bank that is in Exporter Company's country. Advising bank transfers the letter of credit to Exporter Company which is a guarantee for payment. Exporter Company ships the entities and receives the bill of lading. Later on, Exporter Company delivers this bill of lading to advising bank and takes its payment simultaneously. After, the delivery of bill of lading to issuing bank and the delivery of the good, importer company makes the payment to issuing bank and issuing bank transfers the predetermined amount of money to advising bank. There are certain types of letter of credit. First of all, every letter of credit is either revocable or irrevocable. Irrevocable letter of credit cannot be changed without the permission of both exporter and importer companies. Revocable letter of credit can be changed by one of the parties. However, with each change banks get extra charges. Other types of letter of credits are confirmed, back to back, revolving and standby. In confirmed letter of credit the exporter has a double insurance, in back to back letter of credit importer party issues letter of credit for the exporter and the supplier of the exporter, in revolving letter of credit a long term agreement which includes certain milestones is paid in advance but the shipment is made partial and in standby letter of credit for a huge agreement partial payments are fulfilled by the importer.

Cash in advance method

In cash in advance method Exporter Company doesn't have any risk, whereas Importer Company takes the whole risk of the trade. In this method, first either full or fractional prepayment is made by the importer company. After the payment is performed, Exporter Company ships the entities. If Exporter Company has the advantage on the trade because of its credibility or the high demand to its products, this method can be suggested. In international trade it is not logical to insist on this method so much if Exporter Company is also trustworthy. Otherwise exporter party may give up on the trade. Credit card payments and check payments are done by cash in advance method.

Payment Terms for International Trade

Payment Method

Time of payment

Delivery time

Risk of exporter

Risk of importer

summary

Open Account method

After delivery of the entities Before payment Maximum risk No risk First delivery of the entities Last payment

Documents against acceptance method

After shipment before delivery of the entities First shipment second payment Third delivery Almost even Mostly exporter Almost even mostly exporter First shipment of the entities Second payment Last delivery

Documents against payment method

Before delivery of the entities After payment to the bank Almost even Mostly importer Almost even Mostly importer First payment Second shipment of the entities Third delivery Last getting allowance

Letter of credit method

After shipment of the entities After payment Even Even Almost same time, both sides are guaranteed by other parties

Cash in advance method

Before delivery of the entities After payment No risk Maximum risk First payment Last delivery of the entities The aim of picking up a method is to minimize the credit risk and increase utilization. Therefore both sides will be willing to choose the most riskless method. So, first choice of the exporter will be cash in advance and first choice of the importer will be open account methods since they both want to have a transaction without risk. However, counterparty will always ask for another method in order to share the burden of the risk.

Exporter Side

As the exporter party, I choose the methods which decreases exporters' credit risk. Therefore, I prefer cash in advance, documents against payment or letter of credit method to either eliminate my risk or be equal with my counterparty. Now, let's consider that I am a big exporter company that is extremely creditworthy. Instead of dealing with the issues of letter of credit or documents against payment I prefer to use cash in advance method. Since other party will not be doubtful about my shipment it would not object to this payment method. I use this method not to deal with letter of credit issues. Instead of loosing time and extra money for the charges and dealing with paper work, I prefer riskless cash in advance method. However, if my company is not well known in the importer's country, importer country may have doubts about delivery and can ask for letter of credit. Also, if I am not sure about the counterparty I request usage of letter of credit. Therefore, for the new relationships among companies, letter of credit is a good solution. At this point I choose a type of letter of credit which could be irrevocable since it cannot be changed without my permission. However, document against payment is the best way both for me and the importer. This method assures both the delivery and the payment and it is not as expensive and complicated as letter of credit. Therefore, if the importer and the exporter company is even in terms of reputability and credibility this method is the best choice.

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