Export sales - the importance of setting competitive payment terms

Business America, Feb, 1995 by D. Grant McKinnon

The payment terms you set on your export sales can often make or break your efforts to compete in the global marketplace. Yet, all too often an exporter sets, across the board, payment terms that do not correspond to the level of risk involved in the sale. Following is a risk/cost approach that can help you maximize your profits while minimizing your risks.

Export payment terms frequently are based on the generalization that exporting is inherently riskier than selling domestically, and thus requires tighter terms. But setting terms in this way can sabotage a sale just as effectively as can a poor product offering or an inappropriate pricing structure. In any payment situation there is a fundamental tradeoff: the more secure you want the payment terms, the higher the cost to your buyer.

On the one hand, offering terms that are too liberal is likely to cause you greater expense than you can afford and expose your company to a greater risk of loss of an asset than you are willing to accept. On the other hand, offering terms that are too conservative may cause you to lose sales when you probably could have afforded to offer more competitive payment terms.

The answer to this problem is to offer foreign buyers payment terms that reflect the real risk in the transaction and that strike a proper balance between not getting paid and not making the sale at all.

The chart below illustrates graphically the risk/cost tradeoff for a range of commonly used international terms of payment. The relationship between risk and cost is inverse. Therefore, as you move from the left (a position of least risk to you, the exporter, and highest cost to the buyer), to the right, the risk of nonpayment increases while the cost to the buyer decreases.

Cash in Advance

Few would dispute that the cash-in-advance terms represent, for the exporter, the payment option of least possible risk. Unfortunately for the buyer, they are the most costly of terms - funds must be obtained (finance the purchase) prior to receiving the goods. This means either drawing down the buyer's existing lines of credit, or forgoing revenue from internal funds which could otherwise be invested.

Irrevocable Letters of

Credit.. Confirmed and

Unconfirmed

Moving towards the right on the chart the next option is the "Confirmed Irrevocable Letter of Credit." A Letter of Credit (L/C) is a letter sent by the buyer's bank to you, the exporter, promising that it will pay you for goods ordered by the buyer. Payment will be made on the condition that you present to the bank documents proving your compliance with all the conditions set out in the letter of credit. "Confirmed" means that in addition to the promise from the buyer's bank to pay, a second bank acceptable to you (the confirming bank) has added its promise to pay, should the buyer's bank be unable to do so.

The risk comfort afforded to you by an L/C is offset by the cost of the buyer which takes the form of a variety of L/C fees assessed by the buyer's bank and the confirming bank. While L/C fees can vary widely, it is not uncommon for the fees to cost the buyer from 1-3 percent or more of the L/C amount. Moreover, a bank issuing an L/C for its client will consider this equivalent of making a loan and will tie up a portion of the client's (your buyer) available line of credit equal to the value of the L/C.

L/Cs are costly for buyers. While your primary concern should be protecting yourself against nonpayment, many exporters hurt themselves by insisting on L/Cs from foreign buyers whose own creditworthiness supports a degree of risk.

Collection

If the overseas buyer meets creditworthiness standards, a commonly used method of payment is the bank collection. Under this arrangement, you complete a draft, which is similar to a check drawn on your foreign buyer, for the amount invoiced. You then attach to the draft all the documents which the buyer will require to claim the goods upon their arrival in the buyer's country. Finally, you give the entire package to your bank, which forwards them to the buyer's bank. The buyer's bank will only release the documents if the buyer pays the draft amount (in the case of a sight draft) or signs (accepts) the draft (in the case of a time draft). This method of payment gives you control of your goods until the buyer has either paid you or has promised to pay you at a fixed date in the future evidenced by the signing of a widely recognized negotiable debt instrument, a trade acceptance.

It is important to keep in mind that from the exporter's perspective, bank collections are less secure than letters of credit. With a collection transaction, the buyer's bank is making no guarantee that the buyer will either accept the draft when it arrives or will pay the amount called for in the draft. The only obligation of the buyer's bank under a collection transaction is to adhere to the conditions set out in the draft, and to follow certain universally accepted banking procedures dealing with collections.

The flip side of this increased uncertainty for you is reduced cost to the buyer. Since the buyer's bank is not guaranteeing payment, the buyer's existing lines of credit are not affected when the buyer places the order. At a much later date, after shipment and when the buyer is asked by his bank to pay or accept your draft, the buyer is faced with dealing with the cost of the products purchased. Moreover, in contrast to letters of credit fees which represent a percentage of the face value, the collection fees for handling a draft tend to be nominal flat fees, (ranging from $35 to $75 in the United States) representing a significantly lower cost for the transaction to carry.