Exporting overseas is one way for a business to grow, but it won't succeed if the buyers fail to pay promptly. The business world has developed several methods for guaranteeing payment even when the buyer and seller are half the world apart. Letters of credit and documentary collections both guarantee payment when the terms are met, but there are important differences between them.
Letter of Credit
A letter of credit is a commitment by the buyer's bank to pay for the goods, according to the U.S. Department of Agriculture. Before paying, the bank will require the seller fulfill the terms of the letter exactly. Typically, that includes delivering the goods and providing documentation—for example an invoice, a packing list, and a certificate of origin—drawn up exactly as the letter dictates.
In the documentary collection process, the USDA says, the seller sends the shipping documents and a draft for payment to the buyer's bank. The bank, acting as middleman, sends the documents to the buyer, who's the one responsible for paying the draft. Title to the goods passes when the draft is paid off.
Will They Pay?
A letter of credit is considered a reliable guarantee of payment, which makes it an excellent choice when the buyer and seller haven't done business together. If a U.S. bank working with the buyer's bank confirms the letter, it's even safer. Documentary collection is less sure because the money comes from the buyer, not the buyer's bank, so if the buyer refuses to pay for any reason, the seller is out of luck.
A letter of credit is more expensive than documentary collection because of the fees charged by the buyer's bank. If one seller insists on a letter while another offers to accept a cheaper method, such as documentary collection, Traderscity.com states, the lower fees may give the second trader an edge in doing business.
One drawback to a letter of credit compared to documentary collection, Traderscity.com says, is that any departure from the terms of the letter, including improperly prepared documents, gives the bank grounds to refuse payment. The seller must then pay to have the goods returned, find a new buyer or negotiate a lower sales price in return for the bank's acceptance.
Documentary collection is most useful when goods are shipped overseas by boat, the USDA says. The ocean bill of lading is a negotiable document that gives title to the goods; the shipper won't release the goods unless the buyer has the bill of lading, and the buyer can't get the bill without paying the draft.
- cargo ship image by Jeff Dalton from Fotolia.com