The Domestic Credit Manager and an Export Order
Credit Research Foundation is grateful to Doug Stark for contributing this information.
An increasing number of companies today are finding new business opportunities outside North America. This trend is not limited to billion-dollar multinationals; smaller companies also see the benefit of globalization. Today’s American-made products are competitively priced and of high quality, and as a result, exporting to Latin America, Western Europe and Asia-Pacific is almost as routine as shipping to a customer in Boston or Dallas. Furthermore, with the weaker (relatively less expensive) US Dollar over the past decade against most major currencies (with the exception of Latin America), our products are more attractive than ever in overseas markets.
The fundamental procedure that a credit executive follows in making an export credit decision differs little from that used in making a domestic credit decision. In both, the credit executive gathers information on every aspect of the credit risk, and uses the traditional factors (character, capacity, capital, conditions and collateral) to guide the search for information. Although the decision making procedure is the same, the nature of the risk in export trade is greater and more difficult to evaluate than a domestic risk. Accepting the buyer means accepting the risk of the buyer’s country as well. For instance, a buyer’s credit rating may be satisfactory, but payment may be delayed because of exchange restrictions, arbitrary changes in export-import regulations, adverse economic or political conditions
NOTE: This section is geared to the domestic credit manager who occasionally is asked to administer credit and collection activities to a foreign customer.
Handling an export order for the first time
The selling arrangements in foreign trade vary according to the buyers’ creditworthiness and the countries in which they are located. When the credit standing of the buyer is unknown or uncertain, and the risk to the seller is greatest, the cash in advance method is desirable. On the other hand, when little or no risk is involved, export sales are likely to be made on the open-account basis. The following are methods of payment commonly used in export credit.
Letter of credit
Frequently, the reaction to the initial export order is to request a letter of credit (L/C). While an L/C may be the best way to handle a shipment of goods to certain countries, today’s credit manager should look beyond an L/C when selling in the international arena. Nevertheless, it is important to understand how an L/C works.
A false perception exists in many companies today whereby L/C’s are considered to be the most secure way of conducting business overseas. Many credit executives mistakenly believe an L/C is as good as a bank guarantee. Unfortunately, it is not a guarantee of any kind. An L/C is simply a payment mechanism requested by an importer (applicant/buyer) which calls for a payment to be effected from his bank (opening bank) typically through a US bank (advising bank) to a seller/exporter (beneficiary), after all the terms and conditions of the credit have been satisfied. Literally, all the “i’s” must be dotted and all the “t’s” must be crossed before the bank will disburse funds. If an exporter fails to comply with the credit, payment to the beneficiary could be delayed indefinitely
Conditions that the seller must adhere to
- The shipment must be made within the specified time frame.
- The L/C must be negotiated; that is, drawn, on or before the expiration date.
- The draft must be signed or endorsed and the amount of the invoice and draft must agree.
- The bill of lading must be consigned properly.
- The merchandise description must be consistent in all the documents.
- The product must be shipped from the specified port.
Letter of credit administration is an arduous task. In fact, bankers indicate that 70% of all L/C drawings are discrepant; that is, at least one error is made from the above list.
A shipment is made to China and a $50,000 invoice has been posted on the customer’s account when it is learned that the bank is not going to pay due to a discrepancy in the documents.
This situation could have been avoided by asking the customer up-front to make what is known as an “amendment” to the credit. Upon a thorough review of the L/C the creditor would realize that there were certain conditions that were either stated incorrectly or could not be met.
Typical amendments might be:
- To change the description and/or value of the goods.
- Extend the expiration date.
- Or consign the documents to the bank instead of the applicant.
The customer would then make a formal request to the issuing bank to issue an amendment to the credit in order to make the changes required by the seller. Or the buyer could simply instruct the bank to “waive all discrepancies,” meaning that the bank would be obligated to pay the draft when drawn, even though the amount of the credit or the description of the goods was incorrect, or any other discrepancy existed.
In the event the seller did not have the foresight to ask for an amendment, the seller must now ask the buyer to have its bank pay regardless of the discrepancies. However, unless the buyer gives his okay to the bank to transfer funds to clear the draft, the container could sit at the port in Chinese Customs indefinitely, being of no benefit to either party. The customer cannot use the goods, but neither can the seller since the cargo is in a foreign land. Furthermore, the container will undoubtedly incur demurrage (vessel detainment) charges, which can add quickly to the cost of the transaction. Since the container is a long way from home, the seller’s leverage and negotiating strength is weakened since neither party has possession of the goods.
At this point, the seller may have to negotiate a less-then-favorable alternative in order to be paid. The seller may have to reduce the price or offer some other concession. The buyer could walk away from the deal, since the seller failed to comply with the terms of the L/C. The seller could possibly arrange to have the cargo returned to the States, or diverted to another customer in the Pacific Rim, but that action would cost additional money in freight and other charges.
If the goods were custom-made their value to another customer or to the seller are greatly diminished. Accordingly, sellers should use letters of credit only when they are absolutely sure they can comply with each and every condition in the credit.
Banks will always promote letters of credit. They are an excellent source of revenue to the bank generating fees from two places–the buyer and the beneficiary. Each bank in the loop–the opening bank, the advising bank and the negotiating bank–receive processing fees. These fees are either deducted from the proceeds or added to the applicant’s costs–generally both–and they are not cheap. The result is that even if the seller does everything right, invariably margins will be reduced.
Checklist to use on receipt of an L/C
- Is the letter of credit irrevocable?
- Is the paying bank of good reputation?
- Does the letter of credit need to be confirmed?
- Are the beneficiary’s name and address spelled correctly and are there any other misspellings that might create discrepancies?
- Do the dollar amounts and quantities match the quotation?
- Is the letter of credit at sight, or if a term credit, is it as agreed?
- Are the shipping terms correct (for example, FOB, CFR, DES, etc.)?
- Are the documents required as agreed?
- Can you provide insurance as required?
- Are letter of credit fees and costs acceptable?
- Is there sufficient tolerance as to quantity (that is, is the word “about” or an equivalent word necessary)?
- Does the merchandise described match your quotation?
- Are partial shipments allowed?
- Is trans-shipment allowed if necessary?
- Is there sufficient time to meet the latest shipping and negotiation timetable?
- Can you ship from the port of embarkation that is stated?
- Is the shipping destination as agreed and possible?
- Will the style and type of transport document you will receive from the carrier be acceptable according to UCP, ICC Publication 500?
- If the INCOTERM specified is FAS or FCA, will your customer have the ship he has chosen available at the embarkation port specified with the L/C time frame?
- Do you have time to obtain the consular legalization and the other certificates required?
- Can you comply with the pre-inspection (PSI) requirements within the time frame of the credit?
- Can you conveniently supply the type of packing list specified?
- Can you meet marking and labeling requirements?
- If you need to ship on-deck, is this allowed?
A documentary collection is a procedure in which a bank receives documents in trust from the selling (exporting) client with a mandate to have them remitted to the buyer (foreign importer) under the conditions prescribed by the seller. No contractual obligation is imposed on the bank, however, until it has agreed to the mandate. Depending upon the conditions for the release of the documents as set-forth in the sales contract and clearly expressed in the collection instruction, there are several types of documentary collections:
Documents against acceptance
The most common are time drafts known as documents against acceptance. The buyer executes an order to pay, drawn by the exporter on the importer through his bank, and promises to pay the value of the shipment (draft) at maturity (30, 60 or 90 days) from the bill of lading (B/L) date.
Terms are generally keyed to the B/L date rather than an invoice date or estimated time of arrival (ETA) date. The B/L date is easily determinable and universally understood in international commerce.
Once the buyer executes (accepts) the draft, the bank will release the shipping documents so that the buyer can pick up the goods in Customs, after clearing applicable duties, if any, to the government. Without title documents, the buyer simply cannot obtain the goods. At maturity, the buyer is obligated to pay the draft (through its bank) and the monies will be transferred to the drawer’s account. However, the bank has no obligation to pay unless the drawee (the customer) makes payment to the bank to cancel the draft. A draft is not a guarantee of any kind. However, it does afford one additional level of moral suasion. Since the bank is involved in the transaction, the seller can ask the bank to exert pressure on their customer (the buyer), which could prove effective since failure to do so could potentially embarrass the customer. The seller can also protest the draft, which is a form of public disclosure stating that the buyer has failed to honor the draft at maturity.
A second form of documentary collection is a sight draft, or cash against documents, or documents against payment. This is similar to a COD shipment, except it is an international transaction and the buyer must pay the draft (again through its bank) at sight (when it is presented), in order to secure the shipping documents. If the buyer does not pay, the buyer cannot take possession of the goods. Sellers would use this form of payment mechanism if they were unwilling to extend credit to the buyer.
Technically a sight draft may be presented for payment or a time draft for acceptance as soon as it is received by the collecting bank. In practice, however, banks in most countries withhold presentation until the goods arrive in the country. Sellers can appreciate the logic here since the buyer would be reluctant to agree to pay for something before the cargo has reached its destination.
A third payment option is simply open book or open account. The seller approves credit based on the typical character, capacity, capital and conditions considerations. There is really no difference between a customer in Florida or France–other than the fact that they speak a different language. The same issues must be evaluated, regardless of where credit is being extended.
Credit reports, credit groups and credit references are readily available on foreign customers. Credit reporting agencies such as Dun & Bradstreet, FCIB, Graydon and Piguet offer excellent credit reports on potential customers. Keep in mind that each agency has its strengths and weaknesses and you will find over time that one agency is stronger than the others in certain countries. International credit reports are generally not as current or comprehensive as a U.S. report, and they will be considerably more expensive. Most credit reporting agencies offer on-line, Windows-based technology for accessing credit reports.
When dealing with open account customers, sellers must also take into consideration additional factors such as country and transfer risk. This is particularly true with countries in Latin America or the Middle East. When the Mexican Peso was devalued in 1994, payments from Mexican customers came to a standstill for several months, and many businesses (to this day) have never fully recovered from the crisis.
Countries such as Venezuela seem to have ongoing foreign exchange problems where importers are unable to purchase dollars with their local currency (Bolivars). The central bank is reluctant to allow dollars to leave the country eventhough the OTAC has lifted all currency restrictions. This creates a dilemma for U.S. exporters. It is not uncommon to see a perfectly good, creditworthy Venezuelan customer who simply cannot pay because he is unable to purchase dollars.
The Persian Gulf crisis in 1991 created a major problem for Kuwaiti banks. All bank assets were frozen for an extended period of time and U.S. exporters had to wait for months to receive payment for shipments.
Cash in advance
A fourth payment option is simply cash in advance–no different than CIA frequently utilized in domestic transactions to an unknown or non-creditworthy customer. Once the payment is transferred through the bank or the check has been deposited (and cleared), sellers can ship goods to the buyer and forward the documents directly to the customer so that they can clear them at their port.
Role of the Freight Forwarder
The role of the freight forwarder should also be understood in international trade. It is the responsibility of the freight forwarder to handle the documentation once the cargo is booked for sailing. The documentation includes the commercial invoice, draft, collection letter (to the bank), bill of lading, packing slip, and certificate of origin. Not all countries require the same documents, but sellers would always have an invoice, bill of lading and packing slip. (A collection letter and a draft would not be necessary if the shipment was sold on open account.)
Freight forwarders are frequently located near large ports such as Houston, Miami, or Baltimore, but they can also be found most everywhere. As your company becomes more active in export, it is generally a good idea to establish a relationship with a specific forwarder, rather than utilize the customer’s forwarder.
Most companies who are serious about exporting will find it beneficial to find a local representative in the country to which they are doing business. They solicit new business, take orders on the seller’s behalf and assist in collecting the invoice. In other words, they are responsible for the transaction from start to finish. It is nearly impossible to be successful in a foreign land without a full-time presence in that particular country. Managing a customer base half way around the world and 12 time zones removed is no easy task. Therefore, it compels an exporter to find reliable representatives who know their markets, their customers, and most importantly, your products.
Most representatives are paid on a commission basis; 5% of the FOB value is a common arrangement for commodity products. Specialty or value-added products might command a somewhat higher commission. Nevertheless, under no circumstances should a commission be paid to a representative until the invoice is paid in full. That should be so stated in the contract between the exporter/seller and the representative. That way, the representative knows that he is fully responsible to assist in the collection process. If a seller does not get paid, the representative will not be paid.
At some point sellers must also decide what currency will be used in the transaction. While U.S. Dollars are frequently the “preferred” currency (and make it easier for the exporter) sellers must also be able to accommodate the buyer who wishes to be billed in his native currency. Otherwise, sellers may not always be competitive. It is not uncommon to therefore sell in British Pounds, French Francs, Italian Lira, Dutch Guilders, Swiss Francs, Spanish Pesetas, Belgian Francs, German Marks, Australian Dollars, Canadian Dollars or any other hard currency. Generally sellers should avoid invoicing in soft currencies; for example, any currency in Latin America or the developing countries. Even with hard currencies, a lot can happen during a 90-day period when an invoice is outstanding. Sellers could gain or lose 10% or more in a fairly short period of time. Therefore it is wise to take appropriate steps to manage foreign exchange. This is another matter altogether and bears further investigation and review. Exchange risk is a major issue that cannot be ignored.
Collections from the home office to the overseas customer are somewhat different from handling domestic collections. Sellers will need to overcome language barriers and time zones. In Latin America or Canada, U.S. exporters can talk to customers since basically they contend with the same time zones. Going east and west is a problem. Europe can be contacted in the early morning but Asia-Pacific will require the reliance on the representative and the fax machine. Letters are generally a waste of time. Faxes are effective and inexpensive, and are well accepted in today’s global marketplace. A message written in English to an overseas customer will usually be understood when it is received, regardless of its destination. English is a global language and there is bound to be someone at the other end able to comprehend the gist of the message. Phone calls are generally more difficult
It is also helpful for sellers to meet large accounts and develop a relationship with them. If possible, you should visit not only problem accounts but key accounts as well. The overall credit relationship with an international customer is paramount–even more so than with a domestic account. Credit professionals will quickly learn that most overseas customers are receptive to requests for financial statements and will willingly present a current balance sheet and operating statement.