Chapter 20 Summary

LO 20.1 Types of Trade Finance Instruments

• In trade finance, organizations always struggle to determine the pattern of payment methods to allocate responsibility for financing transactions, and thus knowing who would most need liquidity support.
• Using different trade finance instruments (also referred to as methods of payment or payment methods) in different situations is one way companies can reduce this struggle and manage commercial risk present in foreign transactions.
• Four methods of payment were discussed:
  • Open account
  • Advance payment/ cash in advance
  • Documentary collections
  • Documentary credit

LO 20.2 Open Account and Advance Payment Methods of Payment

• In the open account method of payment, the seller ships the goods to the buyer and then later credits the former’s account in their own books with the required invoice amount only after receiving and checking the concerned shipping documents.
• In the advance payment method of payment, first, the buyer credits the seller’s account with the required invoice amount and only then does the seller ship the goods to the buyer. The amount paid could include the entire balance or a part of the entire payment paid in advance of the due date.

LO 20.3 Documentary Collection Method of Payment

• In the documentary collection (D/C) payment method, banks act as intermediaries between the exporter and importer; the exporter’s bank (remitting bank) sends documents to the importer’s bank (collecting bank) along with instructions for payments, and then funds are received from the importer and remitted to the exporter through the banks in exchange for those documents.
• The documentary collection (D/C) transaction uses bills of exchange as a method of payment.
• A bill of exchange is an unconditional order in writing, addressed by one person to another, signed by the person giving it, requiring the person to whom it is addressed to pay, on-demand or at a fixed or determinable future time, a sum certain in money to or to the order of a specified person or to bearer.

LO 20.4 Documentary Credit Method of Payment

• Documentary credit, or letter of credit (L/C), is one of the widely used payment methods in international trade due to its secure and safe nature.
• By issuing a letter of credit, a buyer’s bank obligates itself to pay a supplier’s bank on behalf of a buyer. Once the agreement to use a letter of credit is made and the intermediate goods are shipped, the buyer’s bank has to meet the obligation to pay the supplier’s bank.

LO 20.5 Factoring and Forfaiting

• Factoring is a financial transaction whereby a business sells its accounts receivable to a third party (called a “factor”) at a discount.
• Factoring can be with recourse or without recourse:
  • Under recourse factoring, the client is not protected against the risk of bad debts.
  • Under non-recourse factoring, the factor assumes the entire credit risk.
• Forfaiting is the purchase of a series of credit instruments such as bills of exchange, promissory notes, drafts drawn under usance (time), letters of credit or other freely negotiable instruments on a “non-recourse” basis (non-recourse means that there is no comeback on the exporter if the importer does not pay).
• Factoring is a way of short-term financing the receivables, which are due within 90 days, for instance.
• In forfaiting, medium to long-term receivables are sold.

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