The pros and cons of different payment terms

November 13, 2017 Manage Risk Part 2 of 3 in series

This is the second installment in our three-part series examining how offering flexible payment terms to international customers can boost competitiveness. This piece provides a thorough look at the pros and cons of the four most commonly used payment terms.

Four commonly used payment terms

The trick is to choose payment strategies that will attract overseas buyers and even give you an advantage over your competitors, while keeping your financial risks under control. In most international sales, exporters use one of the following financial instruments to manage payment, each with various strengths and weaknesses depending on the situation.

Cash in Advance

Least risky, but also least attractive to your buy

Cash in advance means just what it says: you’re paid for your products in advance of delivering your goods to the customer.

Strengths	Weaknesses
Least risky form of payment for you—you get your money at the time of the sale. Cash in advance provides the working capital you need to process the order; there’s no strain on cash flow. Verysimple to transact on your part.	This is considered the least attractive and competitive from the buyer’s point of view, as cash in advance is the riskiest way for them to do business—they part with their money upfront but have no guarantee you’ll deliver the goods. This method can also tie up a buyer’s cash while they’re waiting for delivery. If the buyer has to borrow all or some of the amount, this adds another step to their process and, with interest payments, could increase their total cost to buy your product as well. As a result, few international customers will agree to cash-in-advance purchases.

Strengths

Weaknesses

Least risky form of payment for you—you get your money at the time of the sale.
Cash in advance provides the working capital you need to process the order; there’s no strain on cash flow.
Verysimple to transact on your part.

This is considered the least attractive and competitive from the buyer’s point of view, as cash in advance is the riskiest way for them to do business—they part with their money upfront but have no guarantee you’ll deliver the goods.
This method can also tie up a buyer’s cash while they’re waiting for delivery.
If the buyer has to borrow all or some of the amount, this adds another step to their process and, with interest payments, could increase their total cost to buy your product as well.
As a result, few international customers will agree to cash-in-advance purchases.

Letters of Credit

More security for exporter and buyer

A letter of credit, or LC, is a conditional payment method in which the issuing bank promises to pay you once you have complied with all the terms and conditions of the sale. Typically, once you and your customer have agreed on the terms of the sale, your customer arranges for its bank to prepare an LC based on the terms of sale. The bank then send the LC to your bank.

Strengths:	Weaknesses:
LCs provide security to both you and your buyers because they use banks to receive and check documents and to guarantee payment. LCs continue to be the usual method of international payment outside the United States (although this is beginning to change in some established markets). The process is relatively simple: your customer obtains an LC from their bank (the issuing bank), which guarantees you’ll be paid when the conditions of the sales contract have been met. To reduce your risk even more, you can have a Canadian bank confirm the LC. Having a confirmed LC guarantees the Canadian bank will pay you even if the issuing bank refuses to do so; such refusals are rare, but can happen if the customer’s issuing bank finds errors in the LC.	When it comes to competitiveness, LCs have a major drawback in that their fees can be very costly for your customer. In addition, your customer may have to put up collateral with the issuing bank. These funds may be frozen from the day the LC is issued, thus tying up the customer’s cash. Overall, this means requiring an LC can make you less competitive in the eyes of a potential customer.

Strengths:

Weaknesses:

LCs provide security to both you and your buyers because they use banks to receive and check documents and to guarantee payment.
LCs continue to be the usual method of international payment outside the United States (although this is beginning to change in some established markets).
The process is relatively simple: your customer obtains an LC from their bank (the issuing bank), which guarantees you’ll be paid when the conditions of the sales contract have been met.
To reduce your risk even more, you can have a Canadian bank confirm the LC. Having a confirmed LC guarantees the Canadian bank will pay you even if the issuing bank refuses to do so; such refusals are rare, but can happen if the customer’s issuing bank finds errors in the LC.

When it comes to competitiveness, LCs have a major drawback in that their fees can be very costly for your customer.
In addition, your customer may have to put up collateral with the issuing bank. These funds may be frozen from the day the LC is issued, thus tying up the customer’s cash.
Overall, this means requiring an LC can make you less competitive in the eyes of a potential customer.

Documentary Collections

Less risk than an open account, but riskier than an LC

There are two basic types of documentary collections: documents against payment and documents against acceptance. For documents against payment, your Canadian bank sends a set of shipping documents to a correspondent bank in your customer’s market. When your goods arrive at the port of entry, the correspondent bank presents the documents to your customer. The customer pays the bank, receives the shipping documents in exchange, and uses them to release the goods from customs. The correspondent bank then sends the payment to you via your Canadian bank.

The process is almost identical for documents against acceptance, except you allow your customer to pay the correspondent bank on some specified future date. At that time, and on the customer’s payment, the correspondent bank releases the documents to the customer. You are then paid through your Canadian bank.

Strengths:	Weaknesses:
Because the transactions are carried out through banks, with your bank acting as your agent, documentary collections carry less risk for you than an open account. They are also less expensive than LCs, so they may be a more competitive option if your customer balks at paying for an LC.	Unlike LCs, your bank does not assume liability to pay if your customer won’t or can’t pay once the goods arrive. It’s more secure than an open account, but riskier than a letter of credit. Documentary collections should therefore be used with extra caution if the market is politically risky or there if there is otherwise a risk the buyer will not pay.

Open Accounts

If you offer open account terms, you agree to ship your goods to your customer before you get paid. The customer promises to pay within a certain time after receiving the goods, typically within 30 to 180 days.

Strengths:	Weaknesses:
This is a very low-risk option for your customer, since they receive the goods before paying for them. Using open account can help you land a sale, but you should know whether the buyer’s credit is good before you agree to it. In most markets, offering open account terms will make you more competitive, which can increase repeat business and help you build both market share and customer loyalty	The biggest risk with open account is getting paid late, or not getting paid at all. If the customer doesn’t pay, you may also incur costs trying to collect on the debt in addition to the loss from unpaid debt itself. Simply offering longer payment terms won’t necessarily make you the most competitive. It’s best to find out what payment terms are most common for your industry in the target market, and remain within them.