Understanding trade risk - a guide to payment methods

Our TRADE FINANCE services are available exclusively to our clients as an additional feature of our support to their business. TRADE FINANCE is not provided in isolation.


International Trade can seem to be a complex activity. The key to success is understanding and managing the associated risks. The most important risk is that associated with payment.

From the point of view of the supplier (exporter) payment in advance, or at least promptly on shipment, is best for cash flow.  In contrast the cash flow of a buyer (importer) has to fund the time goods are in transit, in distribution or in credit with a customer, and consequently a delay in payment is best.  The issue of risk is at the core of any arrangement to reconcile these views.  Any agreement to delay payment (credit term) must also consider risk to increase with time – the “horizon for risk“.

Open account trading, where the exporter ships the goods to the customer (importer) before receiving payment, accounts for over 80% of global trade. It is the simplest method of conducting business, but it is also the most risky. Valetime Group have trade finance solutions to those trade credit risks.

Letters of Credit (LC) are a traditional method of covering risks, as effectively they transfer the risk to the banks involved. LC’s are considered cumbersome but they can give assurance for a future commitment to payment. Using banks for a collection “at sight”  is more easily workable but documents are exchanged for cash. A term collection can provide credit but it also highlights the risks to secure a future payment.  Trade finance solutions from Valetime Group derived from both LC’s and collections can provide immediate payment to suppliers, and credit terms for buyers.

Covering such risks is without recourse (without responsibility) to either the exporter or importer, though the related costs are borne by them.  The following diagram helps to illustrate the relative risk involved for each party. However within this framework lie a range of variations.

Whatever terms are required, Valetime Group can provide appropriate trade finance solutions to help protect your cash flow and manage any cross-border or International Trade payment risks.

Trade Finance - Credit Risks and Payment Terms

Credit terms explained

Cash in Advance

The importer pays for the goods at an agreed date before the goods are shipped. The supplier (exporter) receives payment while keeping control of the goods.

Confirmed Letter of Credit

This works in a similar way to an Unconfirmed Letter of Credit. The key difference is that the domestic bank confirms the payment obligation of the Letter of Credit issued by the foreign bank. So, if the foreign bank defaults, the supplier (exporter) will be paid by their own or the local domestic bank that confirmed the Letter of Credit.

For further information see: Letters of Credit (wikipedia) and Letters of Credit (Business Link).

Unconfirmed Letter of Credit

This is where the supplier (exporter) receives an undertaking from the buyer’s (importer’s) bank to conditionally guarantee payment to the supplier, providing that all the supplier (exporter) documentation complies with conditions set out in the Letter of Credit.

Sight Collection

This term is often referred to as “Sight Collection – D/P basis” and this case is also known as “Documents on Payment”.

This enables the Supplier (exporter) to maintain control of the goods until they receive payment from the importer. With this arrangement, a bill of lading (which allows the buyer to take control of the goods) is sent via the banking system. It is only released to the buyer (importer) once the buyer has paid.

Term Collection – D/A & Avalisation

This enables the exporter to maintain control of the goods until they receive a commitment from the importer that payment will be made after an agreed term (for example after 180 days). Thus this form of collection is known as involving “Documents on Acceptance” (D/A). With this arrangement, a bill of lading (which allows the buyer to take control of the goods) is sent via the banking system. It is only released to the buyer (importer) on the basis that delivery has been accepted in exchange for a commitment to make a future payment.

Such a commitment to pay is usually effected through a Bill of Exchange from the buyer. When payment of the Bill of Exchange is guaranteed by the buyer’s bank it is said to have been “Avalised”.

Bill of Exchange

An unconditional commitment in writing from the importer (buyer) addressed to the exporter (supplier) formally stamped and signed by the importer, giving an undertaking to pay on demand, or at a fixed or determinable future time, a certain amount to the exporter ( supplier), or to the order of a specified person or to a bearer (the payee).

The key feature of a Bill of Exchange is that, in most countries, it represents an incontestable demand and a powerful way of enforcing legal action on default. When issued to “bearer” it can be negotiated with others for early repayment to provide cash before the due date.

Avalisation

The specific endorsement on a Bill of Exchange by a bank. By doing this, the bank guarantees payment in the event that the importer (buyer) defaults on payment of the bill at maturity.

Term Collection – D/A & Insured

This enables the exporter to maintain control of the goods until they receive a commitment from the importer that payment will be made after an agreed term (for example after 180 days). Thus this form of collection is known as involving “Documents on Acceptance” (D/A). With this arrangement, a bill of lading (which allows the buyer to take control of the goods) is sent via the banking system. It is only released to the buyer (importer) on the basis that delivery has been accepted in exchange for a commitment to make a future payment.

Such a commitment to pay could feature a Bill of Exchange from the buyer but it may not be appropriate for it to have been “Avalised”. Instead of such a guarantee from the buyer’s bank, an alternative arrangement would have been entered into by the buyer to secure future payment to the exporter by means of insurance of the credit.  Such insurance could come from a several forms including forfaiting the Bill of Exchange.

Credit Insurance

Credit insurance is a type of insurance policy purchased by an exporter that, in the event of payment default on an export invoice by the buyer, pays off one or more existing debts.

Forfaiting

Forfaiting is a financial transaction involving the purchase of receivables (for example from a Bill of Exchange with associated credit insurance) from exporters by a forfaiter. The forfaiter takes on all the risks associated with the receivables but earns a margin.

Open Account

This is the most common arrangement, where the exporter ships the goods to the customer (importer) before receiving payment. It is now estimated that over 80% of global trade is conducted on an open account basis. It remains as the simplest method of conducting business, but it is also the most risky. This is usually because there is no form of payment guarantee offered for credit terms which typically vary from 30 to 90 days.

Risk of default on payment, or protection against insolvency of the buyer, can be covered with insurance or can be avoided by invoices that are discounted or factored.

Invoice factoring

Invoice factoring is a financial transaction whereby a business sells its debtors/accounts receivables (i.e. invoices) to a third party (called a factor) at a discount in order to secure an immediate net cash receipt in advance of the credit period associated with the invoice terms.

Invoice discounting

Invoice discounting is a term often misused with invoice factoring. It involves the assignment of debtors / receivables to others as a guarantee to cash advances taken before the credit period associated with an invoice. Factoring is the sale of receivables, whereas invoice discounting involves borrowing where the receivable is used as collateral.



Contact Valetime Group

Now that we have introduced you to our services, find out how we can help you or your business.

contact form | @valetimegroup | phone: +44 1204 497 900.