Introduction to open account
Let’s start with the most basic definition of what is an 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 more often than not. 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.
The ideal use for open account transaction is –
- When there is a strong trust between the importer and exporter
- To win customers with the use of trade finance techniques in competitive markets
- Pros: Open account sale in the global market boosts competitiveness, Helps strengthen good trade relations
- Cons: There is a high chance that the buyer could forgo the obligation of payment once goods are delivered, Additional cost linked with measures taken to mitigate risk
Open account vs letter of credit
A letter of credit is a document which serves the purpose of a guarantee of the buyers’ payment to the seller. This document is issued by a bank on behalf of the buyer to the seller to ensure the full payment on the said date. In case, the buyer misses or is unable to make the payment, the bank will cover the entire invoice of the buyer’s front. So, this letter of credit is essentially a pledge of security or cash issued by the bank. The bank charges a fee, usually a percentage of the amount mentioned in the letter of credit.
Unlike a letter of credit, the risk of non-payment is much higher in an open account transaction which is common in international trade. But one can evade the risk in competitive markets with the help of one of the following trade finance techniques:
- export working capital financing,
- with the help of programs run by the government which guarantee export working capital,
- insurance, and
- export factoring.
Extending an open account transaction may be a financially strenuous choice for the exporters lacking sufficient funds to sustain their business without the immediate payment. In the global market, such a transaction would require working capital financing the export which covers the entire cash flow right from purchasing the raw material involved to the final collection of the sale proceeds. One can get support in the form of loans or line of credit based on assets, or any other personal guarantees. So as the exporter essentially accepts deferred payment, he may have to:
- Get bank financing with support of personal assets
- Financing from government bodies or policies