When you import and export goods, you understand that international trade is not as simple as it looks. There are various processes needed to ensure both parties settle the trade without issues. Depending on the value of the transaction, international trade can become complicated and require lots of processes for a smooth settlement.
While it takes quite a bit of time for buyers and sellers to reach a consensus to trade, dealing with payments is a whole another world in itself. Payment terms determine the conditions under which goods are transferred and payments are made.
There are pros and cons to the different payment terms. Buyers and sellers have to mutually agree on the methods of payment to complete a transaction.
If you’re a new importer or exporter, you need to understand the payment methods in international trade. We will take a look at the different payment methods so that you can decide which works best for you.
1. Cash in Advance via Bank Transfer
Cash in advance is payment received in advance by the exporter before the shipment of goods. It favors the seller by generating cash flow, avoiding credit risks, and retaining ownership of the goods until it reaches the buyer.
While this payment method has the least risk for the seller, it presents the most risk for the buyer.
Without the delivery of goods, the buyer assumes that the seller will hold the trade promise to ship goods for the transferred payment. Cash in advance works when the goods shipped are scarce and in high demand. The exporter is in a strong negotiating position and can demand payment in advance from the buyer.
Buyers looking for flexibility in payment terms will choose other sellers if the only payment method offered is cash in advance. Hence, it is important for sellers to provide additional favorable payment options.
2. Letter of Credit (L/C)
A letter of credit is one of the most secure payment methods available for international trade. It involves payments made by a bank on behalf of the importer.
The letter of credit document is an assurance from the bank that it will pay the exporter for the goods when certain terms and conditions are fulfilled.
The bank inspects the documents that accompany the goods before releasing the payments to the exporter.
Only a credit-worthy importer can obtain a letter of credit. The bank, after checking the documents, will make the payment to the exporter and then collect the payment from the importer.
When importers and exporters enter a new trade agreement, letters of credit are usually preferred as the mode of payment. Since there is no existing relationship, importers and exporters proceed with caution with this payment term. The disadvantages include complexity in setting by the payment method and no way to determine the quality of goods.
3. Open Account (O/A)
Open account payment method involves an exporter agreeing to receive payments 30, 60, or 90 days after delivery of goods. This is a risky payment term for the exporter as goods have to be produced and shipped without receiving payment.
Meanwhile, the importer receives the goods and can sell them and make a profit before paying the exporter at a later date. There is more working cash flow and the importer does not have to worry about funds to take delivery of goods.
Exporters offering open account payment method usually do so for valued customers or to attract a valuable account. They can protect themselves against losses by taking export credit insurance.
Consignment is the riskiest payment method for exporters. Under the method, exporters produce and ship goods to the importer. They only get paid when the goods are sold. Since the trade is extremely risky for exporters, proper insurance and trade finance options need to be in place to avoid massive losses.
This payment method is used by exporters who are looking to enter new markets, reduce the cost of storing and maintaining goods, and move goods much faster. It is usually agreed when there are existing relationships with importers who are reputable and highly trustworthy.