When small businesses sell to each other, they usually offer terms of payment, such as due in 30 days. This method works fine for domestic transactions, but the game changes when a business sells to a foreign buyer.
The seller has no guarantee that the buyer is going to pay and may not have recourse in the foreign courts to pursue unpaid invoices. In other words, selling to foreign buyers involves assuming different levels of risks.
Let's examine the difference between a letter of credit and documents against payment to determine how both buyer and seller can manage these risks.
A letter of credit is a document that enables a buyer and a seller to complete a transaction without either party assuming unnecessary risks. Buyers want the assurance they will receive the merchandise they ordered, and sellers want assurance of receiving payment.
A letter of credit substitutes the creditworthiness of international banks in place of the buyer. When a buyer wants to purchase something from a foreign seller, the buyer goes to their bank and requests the opening of a letter of credit in favor of the seller.
A letter of credit is a document issued by a bank that guarantees the seller will receive payment on time and for the correct amount if the seller presents documents that comply with the terms of the letter of credit.
A letter of credit requires the seller to present certain documents as follows:
- Bill of lading — A bill of lading represents the legal title for the goods being shipped. It is usually negotiable, and the holder has title to the merchandise.
- Sight draft — A draft is a demand for payment for a specific amount and within a certain time frame.
- Commercial invoice — The invoice lists the items being shipped and the amount of the purchase.
- Insurance certificate — An insurance certificate covers any loss or damage to the merchandise while in transit.
The seller will receive payment for the shipment if they present the documents in exact compliance with the terms of the letter of credit. If any of the documents contain the slightest error or omission, the bank may refuse to make payment.
After the buyer and seller have conducted several transactions, the buyer may feel comfortable with the seller's ability to make payments on time. When this happens, the seller could drop the requirement for the letter of credit and agree to a documentary collection procedure.
Under the documentary collection method of payment, the seller ships the merchandise and presents a bill of lading, commercial invoice, draft for payment and insurance certificate to the buyer's bank. The bank passes the documents to the buyer and asks for permission to pay the seller.
If the buyer is satisfied with the documents, they will issue instructions to pay the seller. Unlike a letter of credit, the bank is not obligated to pay under a documentary collection method. Likewise, the buyer could decide for some reason not to pay the seller.
With a letter of credit, the buyer’s bank must pay the seller if the documents presented comply with the terms of the letter of credit. The buyer’s bank is not obligated to pay if the buyer and seller have agreed to a documents against payment method. In this case, the seller is assuming the credit risk that the buyer may not pay.
Bankers charge several fees to issue a letter of credit that could range from 1% to 3% of the amount of the transaction. They charge these fees because they are assuming the obligation to pay if these documents presented are in compliance with the letter of credit. The bank fees for a documents against payment method are considerably less.
Letters of credit are more useful when the buyer’s country is in a state of political or economic instability and has controls on foreign exchange availability. Buyers using a documentary collection procedure may have to purchase dollars, for example, on the black market at higher exchange rates rather than going through the banking system.
A documentary credit, or letter of credit, is more useful when buyers and sellers do not know each other very well. Buyers have the security of documents that verify the quality of the merchandise before having to pay. On the other side, sellers are guaranteed payment when they comply with the terms of the letter of credit.
Documentary collections, conversely, can be more useful and less costly after the parties have become comfortable with each other and do not expect any financial problems to come up. While a bank could reject payment for minor errors in documents presented under a letter of credit, a buyer may be willing to overlook small problems and still approve payment.