1. Advance payment (or cash-in-advance)
In this method, the buyer pays the seller before the goods are shipped. It is the most secure option for the exporter and the least secure for the importer.
How it works:
The buyer typically makes a wire transfer to the exporter's bank before shipment. Some transactions may involve a partial advance payment followed by a final payment upon completion.
Risks involved for the exporter:
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Low risk: The exporter avoids credit risk entirely as they are paid upfront.
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Market competitiveness: This term can be unattractive to buyers, potentially causing the exporter to lose business to competitors who offer more flexible payment options.
2. Letters of credit (LC)
An LC is a financial instrument where a bank, on behalf of the importer, guarantees payment to the exporter, provided the exporter presents the required documents that prove the goods were shipped according to the LC's terms. LCs are a secure and widely used option, especially for new or high-value transactions.
How it works:
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The importer applies for an LC from their bank (the issuing bank).
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The issuing bank sends the LC to the exporter's bank (the advising bank).
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The exporter ships the goods and provides documents to their bank.
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The banks verify all documents, and the exporter receives payment.
Risks involved for the exporter:
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Documentation risk: The exporter must meticulously prepare all paperwork. Discrepancies between documents and the LC's terms can delay or nullify payment.
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Issuing bank risk: Payment is tied to the financial strength and reputation of the importer's bank. This risk is minimized with a confirmed LC, where a second bank in the exporter's country also guarantees payment.
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Cost and complexity: LCs are often expensive and administratively demanding due to bank fees and strict documentary requirements.
3. Open account
Under an open account, the exporter ships and delivers the goods before receiving payment. The buyer is invoiced and agrees to pay within a specified period (e.g., 30, 60, or 90 days). This is the most advantageous term for the importer in terms of cash flow and cost but the riskiest for the exporter.
How it works:
The exporter sends the goods and the invoice directly to the importer. The importer receives the goods and pays the invoice on the due date.
Risks involved for the exporter:
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Credit risk: The exporter bears all the risk of non-payment. This can include the buyer's inability to pay, bankruptcy, or refusal to pay for other reasons.
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Foreign legal risk: If the buyer defaults, collecting the debt can be difficult and costly, as it may involve legal action in a foreign country.
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Market pressure: To compete with local suppliers or in markets where open account is standard practice, exporters may be forced to offer these terms despite the risk.
How to mitigate risk on an open account:
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Export credit insurance: This protects the exporter against the risk of buyer insolvency, default, or political risk in the importer's country.
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Factoring: The exporter can sell their accounts receivable to a third party (a factor) at a discount in exchange for immediate cash, improving their cash flow.
4. Documentary collection
This method offers a middle ground between the security of an LC and the risk of an open account. Banks are used as intermediaries to facilitate the exchange of documents, but they do not guarantee payment.
How it works:
The exporter ships the goods and sends the shipping documents to their bank (remitting bank). The remitting bank forwards the documents to the importer's bank (collecting bank) along with payment instructions. The importer gets the documents only after making payment (documents against payment, or D/P) or accepting a draft for future payment (documents against acceptance, or D/A).
Risks involved for the exporter:
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No payment guarantee: The banks only act as handlers of the documents, offering no guarantee that the buyer will ultimately pay.
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Goods rejection risk: The importer could refuse payment, leaving the exporter responsible for the goods, including potential return freight and storage costs.
krishna
Krishna is an experienced B2B blogger specializing in creating insightful and engaging content for businesses. With a keen understanding of industry trends and a talent for translating complex concepts into relatable narratives, Krishna helps companies build their brand, connect with their audience, and drive growth through compelling storytelling and strategic communication.