Choosing International Terms of Payment for Your Business
According to the World Trade Organization’s World Trade Report 2012, the U.S. is the world’s second largest exporter goods and the largest exporter of services in 2011. With over 95% of consumers living outside of the U.S., expanding your business internationally can provide access to many more potential customers.
If your company is considering global expansion, one of the most important tasks ahead will be to determine the terms of payment and your selection will be dependent on whether you intend to buy from, or sell to, the overseas market. Compared to domestic sales, which are generally cash or credit transactions, international methods of payment may seem complicated.
As a seller, your company will need to offer customers attractive sales terms and payment methods in order to compete in the global marketplace. As a buyer, you will want to pursue a payment method that offers the most protection and the flexible terms of payment.
Choosing Terms of Payment
Understanding the various terms of payment is essential for selecting one best suited for your company. Furthermore, the advantages, disadvantages and risks vary greatly based on if you are the buyer or the seller. Generally, the less risk for the buyer means more risk to the seller and vice-versa.
Here is an overview of five commonly used terms of payment in international trade and the key considerations for each payment method from the buyer’s perspective as well as the seller’s perspective.
This is the least risky choice for the supplier, but the most risky for choice for the buyer.
Buyer’s Perspective: The buyer needs to be confident in the supplier’s ability and willingness to deliver the goods since payment will be made prior to receiving the shipment.
Seller’s Perspective: By requiring advance payment, the supplier runs the risk of attracting less customers since buyers will take on the risk of not receiving the goods after payment and reduce the amount of cash flow during the period after signing the contract, but before the goods are received.
Letters of Credit
A letter of credit, also known as documentary letter of credit, is issued by the buyer’s bank and states the bank’s commitment to act as an intermediary between the buyer and the seller. The bank acts on behalf of the buyer and pays the seller after the terms stated in the letter of credit can be verified through the presentation of all required documentation. This can be one of the safest payment methods for both the buyer and the seller if both parties are willing.
Seller’s Perspective: The seller can find this method useful if there is limited information available about the overseas buyer, but the seller is willing to trust the creditworthiness of the buyer’s bank.
Buyer’s Perspective: The buyer benefits from this payment method over the advanced payment option because the financial obligation does not occur until after the shipment has been made. However, this may not necessarily be the best choice for the buyer since a fee must be paid to the buyer’s bank for this service.
This is similar to a letter of credit in that the bank acts as an intermediary between the buyer and the seller, but does not guarantee payment from the bank. Documentary collection refers to a seller’s instructions to the seller’s bank to send a set of documents (i.e. the title document) to the buyer’s bank. The documents are then transferred to the buyer in exchange for payment and once in possession of the documents, the buyer can take possession of the shipment and goods can be cleared through customs.
Buyer’s Perspective: Documentary collection can be beneficial to buyers who are unwilling to prepay for purchases overseas and do not want to go through the process of obtaining a letter of credit, which is generally a more costly process. However, unlike a letter of credit documentary collection carry more risk to both buyers and sellers. Documentary collection requires the buyer to trust that the seller will ship the goods according to the terms agreed upon in the documents.
In addition, the buyer is only able to obtain the documents, and therefore the goods, if all the agreed upon conditions are met. In the event these criteria are not satisfied, the buyer may not be able to obtain the goods until an agreement is reached and thus there is a risk of not receiving the goods on time. In addition, the buyer will not be able to inspect the quality, condition, or completeness of the order until after the payment is made to the bank.
Seller’s Perspective: In the event that the buyer does not meet the terms of the agreement, the seller will no longer be in possession of the goods and remain unpaid by the buyer. Thus the seller may need to seek payments through other means, such as arbitration or legal means.
Under this method, the goods are shipped and delivered before the payment is due to the seller. In international sales, a payment can be due anywhere from 30 to 180 days and can be based on the shipment or delivery date, a mutual agreement between the buyer and the seller, the regulations of the foreign country and/or the payment terms offered by competing firms.
Buyer’s Perspective: An open account transaction is the most advantageous for the buyer’s cash flow because, unlike other terms of payment, this method eliminates the risk of not receiving purchases after a payment is made. The buyer is in possession of the goods purchased at the time payment is made.
Seller’s Perspective: An open account can be a convenient method of payment if there is a commercial relationship already established with the buyer. Sellers can decrease the risk of using this method by evaluating the buyer’s previous payment history and credit worthiness. Open accounts minimize a buyer’s risk and reduces the amount of effort needed to purchase goods and services. By offering this method of payment, sellers can attract more buyers and stay competitive in the global marketplace, but it also increases the risk of not being paid either on time or at all.
Consignment is similar to an open account transaction in that payments are sent only after the buyer is in possession of the goods purchased. It involves a contractual arrangement with the consignee (i.e. a foreign distributor or agent) that receives, manages, and sells the goods for the supplier who retains title to the goods until they are sold. The seller is paid for sales made on consignment when the consignee abroad sells the goods. Unlike open accounts where the buyer receives the goods and is granted credit for a period of time to make payments, in consignment, the seller retains ownership of the goods until the payment is received.
Buyer’s Perspective: Similar to open accounts, there is little or no risk to the buyer.
Seller’s Perspective: Consignment is similar to open accounts, but sellers take on the added risk of working with a foreign distributor. Not only is the distributor is in possession of the goods being sold, but there is no guarantee that payments from the buyer will be received from the distributor. Selling on consignment can also be beneficial to sellers because it reduces the cost and effort needed to store inventory and makes goods more readily available to sell overseas. To reduce the risk of using consignment sellers should select a reputable distributor.