Any company, large or small, can increase its sales and diversify its customer base by exporting its products and services worldwide. Ninety five percent (95%) of the world’s consumers live outside of the United States. If your company is selling only domestically, it is missing the opportunity to sell to vibrant markets during this US economic downturn.
Of course, there are risks and rewards related to exporting products or services. The most important concern from the seller’s perspective is getting paid as soon as possible, preferably when the order is placed and no later than the date of shipment. In contrast, the foreign buyer wants to delay paying as long as possible and to receive the goods as soon as possible so that it can resell the goods and generate funds to pay for them.
Understanding the fundamentals of trade finance will help to minimize the risk of nonpayment. The hierarchy of risk for the US based exporter, from most secure trade finance technique to least secure is:
Cash in Advance
Cash Installment Payments During Production
Cash Paid in Full Before Shipping
Letters of Credit
Cash in Advance
Payment of cash in advance allows the exporter to avoid credit risk. The most common forms of payment are by credit card or wire transfer. Understandably, the foreign buyer resists this form of payment because it has concerns about the seller delivering as promised, quality, and cash flow. In the free-market, however, a US company that sells for cash only will likely lose business to competitors who offer terms.
Letters of Credit
A letter of credit (“LC”) is a commitment by a bank on behalf of the foreign buyer that payment will be made to the seller once certain terms and conditions are verified to the bank. The LC is the most secure instrument available to international traders. The seller is relying on the creditworthiness of the foreign bank as opposed to that of the buyer. The buyer is also protected because the bank has no payment obligation until it is presented with proof that the goods have been shipped or delivered as promised.
A documentary collection (“DC”) is a transaction where the selling exporter entrusts the collection of payment to its bank, which sends documents to the buying/ importer’s bank. Funds are received by the seller from the buyer through the exchange of documents between their banks. The banks are acting as facilitators in this situation and there is no verification that the representations in the documents exchanged are authentic. Also, there is very limited recourse for nonpayment available to the seller/exporter.
In open account transactions, the seller ships and delivers the goods to the buyer and waits for payment, which is usually made within 30 to 90 days. The open account is very attractive to the buyer because it can resell the goods to generate cash to pay for them. Obviously, this is the highest risk option for the seller and is only done because of the intense competition in export markets.
In an ideal world, the US exporter would sell for only cash in advance. In the real world, a seller’s senior management must evaluate the risks and rewards of the terms of payment and make a business decision.
How Should Payment be Made?
Use cash in advance when:
The foreign buyer is a new customer or has a short operating history,
The foreign buyer has an unsatisfactory or unverifiable credit history,
The foreign buyer’s home country has high political or commercial risks – as in emerging markets, or
The seller’s product is very unique and in high demand.
Use letters of credit when:
The foreign buyer is a new customer, has a short operating history, or has unsatisfactory or unverifiable credit while its bank is stable and creditworthy and is experienced in LC transactions and
The added expense of the LC process does not substantially undermine the profitability of the sale.
Use documentary collections when:
The seller and foreign buyer have a well established relationship,
The seller is confident that the buyer’s country is politically and economically stable,
An open account sale is too risky and the LC is not acceptable to the buyer, and
Both facilitating banks have experience in trade finance.
Because documentary collection transactions provide the seller/exporter very little recourse in the case of nonpayment by the buyer, they should only be used when all of the above conditions apply.
Use open accounts when:
The buyer is well known and considered low risk,
The seller will win the sale in a very competitive market,
The trade relationship will be ongoing, and
Trade finance techniques are available to reduce risk.
Trade Finance Techniques and Open Accounts
In order to mitigate the risk of selling on open account terms, every effort should be made to obtain support from trade finance agencies. These may include: (a) export working capital financing, (b) government guaranteed export working capital programs, (c) export credit insurance, and (d) export factoring.
Export working capital (“ECW”) loans are generally made by commercial lenders. The ECW funds are commonly used by the exporter to purchase raw materials, pay for labor, and build an inventory. The funds can also be used to finance receivables or pay for letters of credit. This allows companies that are new to export sales to contract for single or multiple export transactions. The EWC loan is usually secured by assets, accounts receivable, and personal guarantees.
Government guaranteed export working capital programs are offered by the US Small Business Administration (“SBA”) and the Export-Import Bank of the United States (“EXIM”). These agencies guarantee the loans made by the commercial lender to the exporter. As a rule of thumb, the SBA manages loans under $2 million and EXIM manages loans over $2 million.
Exporters can increase their sales by offering open account terms to their foreign customers backed by export insurance (“ECI”). This provides protection against both commercial losses such as nonpayment and bankruptcy and political losses as a result of war or nationalization. ECI policies are offered by many private companies as well as EXIM. Premiums are determined on a transaction by transaction basis by evaluating various risk factors. In most cases, the cost of insurance is less than the fees charged for letters of credit.
Factoring is when the seller transfers title to its short term accounts receivable to a factor at a discount in exchange for cash. The factor handles collecting from the buyer and assumes the risk of nonpayment thus maximizing the seller’s cash flow. Factoring is generally only available to established exporters selling to established markets, not developing countries. Usually, factoring is more costly than credit insurance.
Accessing foreign markets and selling to the remaining 95% of the world’s consumers is a genuine opportunity for your company. Given the shifts in the global economy, exporting may be critical to your company’s survival.
For support in your company’s export sales, contact Randolph M. Wright at our Birmingham office (248) 645-9680.