Magazine article Business Credit

Climbing the Risk Ladder

Magazine article Business Credit

Climbing the Risk Ladder

Article excerpt

Addressing Payment Risk in International Transactions

As more companies take advantage of global business opportunities and begin to trade abroad, credit and financial managers of importing firms must take the necessary steps to reduce payment risks in the event their shipments do not arrive as ordered, intact, or on time. Exporting firms, on the other hand, should be reminded that their efforts are for naught if they do not get paid. There are four primary methods of making payment. Each method offers advantages and disadvantages depending upon the relationship between the buyer and seller. The "risk ladder" shown in Table One displays each of these payment methods arranged in terms of the degree of payment risk assumed by the seller.

As sellers move down the ladder from open account toward cash in advance, they reduce their degree of payment risk. Buyers have the opposite experience, with open account terms being the most advantageous and cash in advance the least beneficial. To find out why, let's review each of these payment mechanisms in detail.

Open Account Operates on Trust

In an open account transaction, the buyer receives the goods, followed by the invoice and related shipping documents, and then makes payment. Both parties typically are well known to one another and the terms of payment are based primarily on trust. The seller is relying completely on the buyer to pay the account as agreed. There is no risk to the buyer, who has both the goods and the funds simultaneously. If the buyer reneges on the contract, or refuses or delays payment, the seller may have to take legal action. A large percentage of the world's commercial transactions are conducted on open account. However, when substantial sales are involved, or when the parties are unfamiliar with one another and oceans separate them, stricter controls are advised for both sides.

Collections Method Accepted Worldwide

International collections provide a means of exchanging goods for payment with greater control than for sales on open account. They frequently are used instead of letters of credit when the credit worthiness and performance of the parties to the trade transaction are reasonably well established. The collection method is a universally accepted banking mechanism governed by the Uniform Rules for Collection.

In a typical transaction, the seller maintains control over the merchandise while the seller's bank (or remitting bank) transmits the seller's documents (e.g. commercial invoices, packing lists, bills of lading) to the buyer's bank (or collecting/presenting bank). The collecting/presenting bank informs the buyer that it is holding these documents pending payment. This action is called a "presentation." Only when the payment or acceptance to pay at some future date as agreed occurs, does the collecting/presenting bank release the shipping and title documents to the buyer.

Table Two traces the flow of collection documents and payments in a typical international transaction.

Speed Speaks for "Direct Send" Method

Exporters can use a "direct send" method of collection to expedite the process even further. Here, the seller, or its designated freight forwarder handling the shipment, prepares and sends documents directly to the collecting/presenting bank. A copy of the executed collection form is then sent directly to the remitting bank. This collection method can reduce document transmittal time and ultimate collection of funds by several days.

Bank Communicates "SWIFT"ly

The remitting and collecting/presenting banks only act as collection agents. They execute the seller's instructions regarding the presentation and release of documents/merchandise to the buyer and regarding payment or non-payment of funds to the seller. Instructions are communicated through banking channels via SWIFT (the Society for Worldwide InterBank Financial Telecommunications).

Table One
Risk Ladder
Seller's Perspective   Payment Mechanism    Buyer's Perspective
High Risk                                   Most Advantageous
|down arrow~           Open Account         |up arrow~
|down arrow~           Letters of Credit    |up arrow~
|down arrow~           Cash in Advance      |up arrow~
Low Risk                                    Least Advantageous
The Ladder of Risk displays payment mechanisms arrayed in terms
of the level of payment risk assumed by the seller. … 
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