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Methods of payment in trade finance

Methods of payment in trade finance

Trade finance personifies financing for trade. It is a specialist finance that can help a company to grow and increase trade. Global trade finance helps business in releasing working capital from domestic trade transactions.

Export process is lengthy, cumbersome and expensive and involves certain risks too. Moreover, payment terms can be long and very hard to manage. Even after careful time planning and financial management, exporting commodities can place incredible strain on your business. International trade finance thus becomes a key factor in the competition among various business.

The crucial importance of trade finance is it exists to mitigate, or we can say to reduce the risks involved within the trade transactions. These risks can be payment risks or corporate risks.

There exist two players in a trade transaction:

  1. the supplier, who requires payment for the goods being sold,
  2. the buyer/importer who wants to make sure that he pays for the correct quality and quantity of goods.

Methods of Payment

Financing techniques in international trade includes:

  • Cash in Advance
  • Letter of Credit
  • Documentary Collections
  • Open Account

These methods provide customers with business finance solutions and act as a life blood of business.

Letter of credit

An LC is a financial document which is provided by a third party i.e. a bank or a financial institution that guarantees the payment for goods and services to the exporter once the exporter submits the required documents. A letter of credit has three important elements – the beneficiary i.e. seller who is the recipient of the LC, the applicant i.e. buyer who buys the goods and services and the issuing bank that issues the LC on the buyer’s request.

It is the most versatile and secure instruments for international traders. LC can also be termed as letter of guarantee. The required documents are responsible to protect the interests of both the buyer and seller as they can get paid immediately or at a later predefined date. If the required payment is done immediately to the seller than we call it on sight, but there are chances that the importer might do the payment once the shipment has reached the destination.  It can be classified into two categories i.e. revocable and irrevocable. Irrevocable cannot be changed until both parties agree over it whereas, revocable can be changed as per one. Thus, revocable is inadvisable to avoid risks.

Documentary collections

A documentary collection is a trade transaction whereby the exporter trusts the collection of payment from the exporter’s bank i.e. remitting bank, which is responsible for sending documents to the importer’s bank i.e. collecting bank, along with the specific instructions for payment.

Payment is received from the importer and the importer's bank and is further remitted to the exporter through the banks involved in exchange for the required documents. In documentary collection there is involvement of a bill of exchange or we can say draft which requires the importer to pay the funds either at sight or on a specified date as described within the terms of documentary collection. There is an affiliated collection cover letter for the documentary collection that gives instructions and specifies the documents required by the importer for the acceptance of the goods and for customs clearance at its port. D/Cs offers no verification process as the banks are only responsible for the transfer of documents from exporter’s bank to importer’s bank; they just act as an agent or facilitator.

Open account

In simple terms, an open account transaction is essentially a form of sale where the goods are delivered before the payment is due. The payment for an open account transaction is typically received within 30-90 days after delivery. This open account sale is usually done between trusted international traders as it seems to be more beneficial for the importer in terms of cash flow and cost, while it evidently has a factor of risk involved for the exporter.

Owing to the growing competition, foreign buyers request for this open account sale as often when exporters decline such credit, they lose business to their competitors. This extension of the open account transaction is also a common practice abroad. Therefore, under pressure exporters seem to consider this transaction often. That said, before agreeing to such transactions the exporters should thoroughly vet the political, economic and even commercial risks involved which may prevent the full payment to be received on time.

One can bypass the pressing risk of non-payment by including trade finance techniques in the entire bargaining like factoring or export credit insurance. There is even an option for exporters to request for export working capital financing to make sure that they have enough financing for production to go on credit while waiting for payment from the importer.

Cash in advance

With this payment method, supplier can avoid credit risk as payment is received before the goods are transferred. In this most commonly used option are wire transfers and credit cards. From recent times escrow services are also becoming another option for small export transactions. Moreover, it is termed as the least attractive option for the buyer as unfavourable cash flow is generated by this. Importers are also concerned that the products may not be sent if payment is made in advance.