How to Start an International Trading Business – Part 5
Contents
Introduction
This is the fifth and last article in our series about international trading. In our first post, we gave an overview of how to start an international trading business. We followed up that article with posts about international trading regulations, documentation requirements, and the risks involved in completing international trade transactions. This final article provides information on the options available for financing international trade or to put it another way, how the seller or exporter gets paid.
Let’s take on the easier payment options first, and then we will migrate to the more complex, lesser-known financing alternatives. We should say at the outset that the choice of payment method depends on various factors, including the type of goods, the value of the transaction, the level of trust between the parties, and their respective creditworthiness.
Methods of Payment in International Trade
- Open Account – When Walmart buys toys, BBQ grills, T-shirts, and lingerie from factories in China and Vietnam, they buy on open account. This means that the factories give Walmart a specific number of days (usually 10 or 30) to pay once the goods have reached a Walmart warehouse in the U.S. or France or wherever the warehouse is located. The factory provides these advantageous credit terms for two reasons. First, they want to sell large volumes of goods to Walmart and provide these payment terms as an incentive to buy from them and not another factory. Secondly, the factory in China or Vietnam trusts Wal Mart. Would the factory like for Wal Mart to pay for the goods before they are shipped or even before they are manufactured? Of course, but that is never going to happen.
- Cash in advance – The opposite of Open Account is Cash in Advance. In an earlier blog post in this series, we mentioned that a buyer wanted to purchase 50,000 smartphones from a manufacturer in the Middle East. The buyer intended to resell the phones in Uganda. The buyer was a small NGO (non-governmental organization) that was trying to help the poor in Uganda get access to the rest of the world through the Internet. Smartphone ownership in Uganda is quite low. While the seller recognized that this was a worthy cause and was highly motivated to sell the phones, they could not take on the credit risk associated with a small NGO operating in Uganda. The smartphone manufacturer asked the buyer to pay for the products before they were shipped.
- Consignment – An international consignment transaction is based on a contractual arrangement in which the foreign distributor receives, manages, and sells the goods for the exporter. The exporter retains ownership of the goods even though they are now in the hands of the foreign distributor. Furthermore, and best of all, the distributor does not have to pay for the goods until they are sold. Ever heard of a brand of farm and construction equipment called Kubota? Kubota is a Japanese company with dealers all over the world. With many of its dealers, Kubota ships products to the dealers from its factories in Japan on consignment and when the products are sold to contractors or farmers, Kubota in Japan gets paid by the dealer.
- Documentary Collection – According to Investopedia, Documentary Collection is an arrangement whereby the exporter receives payment from the importer in exchange for the shipping documents. Shipping documents include a commercial invoice, certificate or origin, insurance certificate and a packing list. The most important document in this transaction is the bill of exchange which is the formal demand for payment by the exporter to the importer. Documentary Collections are less common than letters of credit and while they can be less expensive to complete, they are often riskier than the letter of credit which is described below. For a better understanding of the details of Documentary Collections and how they work, you should contact your international banker.
- Letter of Credit (LC) – Letters of Credit are the most frequently used payment methods in international trade transactions. An LC has been described as a financial handshake. An LC guarantees payment by the importer (buyer) to the exporter (seller). LC transactions can be very complex. Let’s begin our discussion by describing the participants in a transaction:
- Buyer (Importer): The party purchasing goods or services.
- Seller (Exporter): The party selling the goods or services.
- Issuing Bank: The bank that issues the LC on behalf of the buyer.
- Confirming Bank (Optional): The seller’s bank that guarantees the issuing bank’s payment. This is a good time to mention that only major international banks participate in the LC market and, importantly, they all know each other quite well.
How an LC transaction works:
- Agreement: Buyer and seller agree that the LC will be the method of payment.
- LC Application: Buyer applies to their bank (issuing bank) for an LC, specifying the terms of the transaction (e.g., goods, price, documents required). Most active traders have a pre-established LC line of credit so that they don’t have to go to the bank each time they need to have an LC issued. In today’s digital world, LC’s are typically issued from an online app.
- Issuance: Issuing bank issues the LC, promising to pay the seller upon meeting specific conditions.
- Transmission: Issuing bank transmits the LC to the seller’s bank (confirming bank, if applicable).
- Shipment: Seller ships the goods and presents required documents (e.g., bill of lading, invoice) to their bank.
- Payment: Confirming bank (if involved) verifies documents and forwards them to the issuing bank. If all conditions are met, the issuing bank pays the seller.
- Repayment: Buyer then repays the issuing bank for the payment made to the seller. If the buyer has an established line of credit, he simply debits his checking account and credits his line of credit in his banking app.
Benefits of Using Letters of Credit
While letters of credit can be costly and, in many instances, quite complex, there are definite benefits to financing international trade with LC’s. For example, using an LC can reduce risk for both parties, involving international banks will add credibility and security and finally, most transactions can be completed with fewer problems. Remember, as we have mentioned several times, LCs are complex and must be carefully drafted. It is also important to remember that there are always fees to be paid when issuing an LC. And one more thing, LCs only guarantee payment. They do not guarantee that a cargo won’t be damaged or that there will not be fraud or disputes.
A recent client launched an international trading business that is buying agricultural and petroleum products from sellers around the world and exporting them to buyers in Africa. He has an excellent network of buyers and sellers. However, before he was able to execute his first trade, he needed an LC line of credit from a bank in Dubai. The bank asked for a business plan. That is how Cayenne Consulting can help.