Managing international financial transactions is becoming more important, especially to the welfare of small exporters who generate a greater and greater share of their profits from international trade. Thus, the ability of the exporter to obtain export working capital and offer attractive credit terms to foreign importers can generate a much needed edge over the competition. And based on the exporter’s ability to obtain working capital and the method of payment he/she chooses to accept from the importer can mean the difference between financial success or failure. Consequently, working capital loans and terms of payment, including their obvious and hidden risks, are aspects of international trade that the exporter and lender must thoroughly identify and understand.

A typical trade cycle covers the period from the time a sale is made, through the time a company begins to outlay cash on design, raw materials, labor and other production expenses, until the point when the final payment is collected. In terms of overseas sales, this cycle has a critical mid-point at which the product is packaged, shipped to port and loaded on board a vessel or a plane. Thus, before the shipping point, financing required by the exporter is considered “pre-export financing.” Financing required after shipment to pay for the goods is considered “post-export financing.”

Pre-Export Finance

In many cases, a relatively large financial commitment is required to produce goods for overseas sales. Consequently, the exporter’s need for pre-export financing can be high. Pre-export financing generally refers to the manufacturer’s financing of materials and labor for export using working capital loans.

While the demand for export working capital is high, especially by small businesses, obtaining it can be very difficult. When exporters apply for working capital loans, the amount made available will be collateralized by a lien on their inventory and receivables according to a prescribed formula. Unfortunately, lenders generally exclude overseas receivables from the borrowing base, and consequently, deny export working capital loans.

In addition, many international contracts call for the development of specialized products the U.S. manufacturer cannot always unload in the domestic market if the export sale does not materialize. This added risk also works against the exporter. As an alternative, in an attempt to maintain a positive pre-export cash flow, the manufacturer may request that the overseas importer provides progress payments before the product is exported. This will enhance the exporter’s cash flow, but may exact an important commitment the buyer is unwilling to make. As a result, export working capital is an important component to export success.

Noted earlier, in a typical domestic transaction, receivables are considered collateral which helps obtain the needed working capital. For example, assume that ABC manufacturing company located in Texas obtains a $500,000 order from a New York City distributor to produce lamps. To complete the order, ABC purchases materials, which include metal housings, clamps, shades and light bulbs. As the materials arrive, the company assembles and ships the lamps in increments over a period of one year. Upon each shipment, ABC invoices the New York buyer on a 30 day open account.

When examining this scenario at a particular point in production, we find that ABC company has $100,000 in raw materials, $75,000 in finished goods, and $150,000 in accounts receivable. To calculate the borrowing base on collateral a lender is generally willing to incur on a working capital loan, it will use an internal method of computation often called a borrowing base certificate.

In our example, the borrowing base would be $197,500. This is determined by accepting 40 percent of raw materials ($40,000), 50 percent of finished goods ($37,500), and 80 percent of the value of receivables ($120,000). As the raw materials become finished goods, and the finished goods are converted in accounts receivable, the borrowing base would be adjusted to reflect the new situation and funds would be released from the bank based on a predetermined schedule.

On the other hand, if the buyer is located in Mexico City, instead of New York City, a lender would not consider the foreign receivables as collateral if the deal is simply based on open account terms. However, if the deal was structured as a letter of credit, or the receivables were insured by an acceptable insurance provider, the bank would consider the receivables as collateral and add it to the borrowing base. (Note: unlike most lender practices, the U.S. Small Business Administration Export Working Capital Loan program considers the receivables as collateral before they are created. In other words, before the goods are shipped.)

Insuring the exporter’s accounts receivable under open account terms is important for a variety of reasons. It not only protects the exporter and lender against the failure of foreign buyers to pay their credit obligations, but as stated above, it increases the exporter’s borrowing base, and in turn, improves his/her position to obtain often needed working capital. In addition, insuring foreign receivables encourages exporters to offer foreign buyers competitive terms of payment, supports an exporter’s prudent penetration of higher risk foreign markets, and gives exporters and their banks greater financial flexibility in handling overseas accounts receivable.

When the international receivables are insured, an export trade financing situation becomes very similar to a domestic trade financing situation in terms of risk. Thus, the primary difference becomes the location of the buyer.

Post-Export Finance

“Post-export finance” refers to the financing obtained by the foreign buyer to pay for goods imported. Once a shipment is en route to the customer, only one question usually consumes the mind of the exporter: When is pay day? But before asking this question, it is necessary to negotiate up front who will be responsible for payment. And the options are not always simple. For example, payment could come from the customer, the customer’s bank, the exporter’s bank, a forfaiting company, or from the proceeds of an Ex-Im Bank guaranteed loan to the foreign buyer.

Depending on the exporter’s need for control, certain methods of payment may be demanded. For instance, a principal function for payment through the use of a letter of credit is to ensure control of goods so the buyer cannot clear the product through foreign customs without paying the seller.

Three categories of financing — short, medium and long-term — are used to define the length of time post-export financing, or “after the sale” financing, will extend. Thus, short-term financing generally extends over a period of six months to one year. (Note: In addition to its use in the post-export phase, short-term financing is typically used for export working capital in the pre-export phase.) Based on the circumstances (reputation of buyer, destination country, etc.), U.S. exporters may wish to finance specific transactions on behalf of their customers to make deals more attractive, or in many cases, possible. This may by a accomplished by various methods. The exporter may:

• Ship on open account terms, carry the receivables and, perhaps with export insurance in place, borrow from a domestic bank to achieve this;
• Draw a bill of exchange on the importer, ask the importer’s bank overseas to avalize the draft (see details later in this chapter), and then sell it to a third party;
• Send the goods on collection under documents against acceptance (see details later in this chapter). When the overseas buyer has accepted the draft and the collecting bank has advised a maturity date, the exporter can ask his/her bank to purchase the acceptance;
• Draw a draft and present documents under a usance letter of credit (see details later in this chapter).

Medium-term financing extends from the short-term period up to five years. It is very uncommon for small businesses to carry a medium-term debt on their balance sheets when domestic U.S. banks do not accept foreign receivables as collateral for working capital. For sales requiring financing during this period, exporters will often resort to:

• The forfait market (see details later in this chapter), where the exporter draws a draft or a series of drafts with varying maturities which are guaranteed by a bank in the importer’s country and then sold, without recourse, in the international forfait market;
• Ex-Im Bank guaranteed loans (see Chapter Four), where Ex-Im Bank protects a U.S. lender or an overseas bank against commercial and political risks arising from the import of U.S. goods;
• Ex-Im Bank medium-term single buyer policy, insuring loans repayable over a period of one to five years.

Long-term financing is generally considered financing from five to seven years, up to a period of 20 to 30 years. This length of financing is uncommon for small firms. Nevertheless, the forfait market may be helpful in financing beyond five years for certain countries. And, the more politically and economically stable a country, the better the chance that long-term obligations will be acceptable to the forfait market.

Post-Export Payment Mechanisms

In any foreign or domestic transaction, cash in advance of shipment is the least risky and, therefore, the most preferable to the exporter. Conversely, it is to the advantage of the importer to delay payment as long as possible. Both parties desire to keep cash available to service non-related accounts payable, earn interest, and/or finance other projects. As a result, both must negotiate terms to achieve a level of mutual satisfaction. In order to remain competitive, the exporter may need to extend some credit. However, as the terms of payment become more beneficial to the importer, the exporter’s risks grow.

Borrowing money in most developing countries is often difficult and expensive. If the exporter can extend more liberal payment terms, he/she may be able to seize a competitive advantage. However, the exporter and lender must always weigh the risks against the benefits. Even if the buyer is a well known entity and considered trustworthy, there are more factors to consider if one is extending credit terms. Difficulties with foreign banking systems, local customs officials and practices, and political instability can result in the exporter not getting paid — ever. Customs documentation in developing countries is often confusing and changes frequently. Seemingly simple issues, such as required documents, language used, number of copies, inspection requirements, and signatures can lead to problems that delay payment.

Several factors must be considered in determining what level of risk the exporter and lender are willing to incur regarding accounts receivable. These include bank and other supplier references, the depth and experience of the business relationship, the buyer’s financial position and creditworthiness, number of years in business, etc.

Various methods of payment that accommodate the needs of the exporter and importer. These include the following, from least risk for exporter to most risk:

• Cash in advance
• Letter of credit (L/C)
• Open account (with insurance)
• Documents against payment (D/P)
• Documents against acceptance (D/A)
• Open account (without insurance)
• Consignment

Cash in Advance

Cash in advance is the most desirable method of payment for the exporter since the exporter is relieved of collection and gains immediate use of the funds. This method, however, poses the greatest risk to the importer and is only likely to be acceptable if the purchase is very small, or the buyer is highly motivated to obtain a unique product and is confident of the supplier’s ability to deliver.

Documentary Collections

Documentary collections is a method of obtaining payment for goods where the exporter ships the goods and instructs his/her bank in writing to collect payment from the importer in exchange for the transfer of title, shipping and other documentation allowing the importer to take possession. Documentary collections include documents against payment (D/P), documents against acceptance (D/A), and letters of credit (L/Cs).

Documentary collections involve the use of drafts. A draft, a common version of a bill of exchange, is an unconditional order in writing prepared by one party (drawer) and addressed to another (drawee), directing the drawee to pay a named person (the payee) a specified sum of money. A draft can be clean (one that has no documents attached and is usually handed to a bank for collection in a foreign country) or documentary (one that is accompanied by documents needed to complete an export transaction).

In general, there are two categories of drafts: those that are payable immediately, and those that are payable at some time in the future. A sight draft, which is payable immediately when presented to the paying party, is an example of the former category. The latter category inclues time drafts and date drafts, also known as usance drafts. Time drafts are payable at a specified number of days in the future (i.e. in 30 days after sight). Date drafts are payable on a specific date in the future (i.e., March 25).

Another common version of a bill of exchange is a promissory note. It is a transferable, negotiable instrument that is evidence of a debt contracted by the borrower to the creditor, whereby the borrower or issuer promises to pay a certain amount by a specific date, and at a particular interest rate.

Letters of Credit (L/C)

A letter of credit (L/C), formerly known as a documentary credit or documentary letter of credit, is by far the most common and mutually secure method of payment in international trade. Similar to documents against payment, the exporter receives payment prior to the importer receiving the goods. For all practical purposes, the L/C shifts the risk from the foreign buyer to the buyer’s bank. Small business exporters tend to use L/Cs at sight.

The L/C is issued by the importer’s bank, known as the issuing or opening bank, which promises to pay the exporter (beneficiary) against documents stipulated in the L/C. This payment is directed through a U.S. bank, known as the advising bank. When an L/C is issued, the issuing bank is effectively substituting its creditworthiness for its customer, the importer. If the exporter presents documents in compliance with all terms and conditions of the L/C, the issuing bank must legally pay the exporter, whether or not the importer has paid. Therefore, before an issuing bank issues an L/C for a customer, it must ensure that its customer has access to the required funds, or it will insist that the funds be deposited in the bank prior to issuing the L/C.

The advising bank has a duty to the exporter to authenticate the L/C and to advise the exporter of its receipt. However, it does not assume any responsibility for payment should the importer’s bank default. The issuing bank usually will designate a U.S.-based correspondent bank as the advising bank unless otherwise requested by the exporter.

A confirmed letter of credit is the most secure L/C for the exporter. The confirming bank in the United States, usually the advising bank, will guarantee payment to the exporter, then seek reimbursement from the issuing bank. If the issuing bank defaults, the confirming bank must still cover payment to the exporter under the L/C. All letters of credit are irrevocable unless they state otherwise.

For the sake of familiarity, the U.S. exporter may deal directly with his/her local bank, which may not be the advising bank, and instruct the local bank to deal with the issuing bank usually through the U.S. advising bank. This being the case, the local bank would be called the negotiating or paying bank. Otherwise, the advising bank likely would assume these titles.

If stated in the L/C, the exporter may assign all or a portion of proceeds (but not the right to present documents) to a second and/or third party. This ensures that all parties (i.e., a U.S. manufacturer, export broker and lender) will be paid what is owed to them. Prior to the exporter receiving payment or the importer gaining possession of the merchandise, several documents called for in the L/C must be furnished (i.e., bill of lading or airway bill, commercial invoice and packing list), proving the goods have been shipped as ordered.

Revolving, Transferable, Back-to-Back, Standby and Red Clause Letters of Credit

A revolving L/C is designed to satisfy the needs of the exporter and importer whose transactions are repetitive. It allows a single revolving L/C to cover several regular transactions. For example, it covers the exporter who may ship products every two weeks for a period of three months to the same importer. A revolving L/C may indicate a maximum dollar amount that may be available at any one time.

In many circumstances, a small U.S. exporter is not able to finance a high-value purchase from U.S. suppliers for shipment abroad. In response, he/she may request a transferable letter of credit. This is a documentary letter of credit that is marked as transferable. It will be issued in favor of the exporter and transferred to the ultimate supplier. If it allows partial shipments, it may be transferred to one or more beneficiaries, where each party receives its own portion of the proceeds. The second beneficiary, however, is not allowed to transfer to a third beneficiary unless specified in the L/C. When using a transferable L/C, the buyer is made aware of the supplier. This can cause a problem for the exporter if, in the future, the buyer attempts to buy directly from the supplier. Transferable L/Cs often are used when:

• The first beneficiary is unable to supply some or all of the merchandise called for in the letter of credit;
• The first beneficiary acts as agent of, or principal supplier to, the applicant (i.e., importer). Such L/Cs are usually issued for a large amount where the first beneficiary is responsible for distributing portions of the L/C to various suppliers; or
• The first beneficiary is unable to secure back-to-back letter of credit facilities from bankers.

Underlying any transferable L/C is the request of the beneficiary to have it made transferable. This indicates to the applicant that the party supplying the goods is not the original supplier.

A back-to-back letter of credit is a documentary letter of credit opened at the request of an exporter who is also the beneficiary of an export letter of credit (the master L/C). Banks usually open these for a middleperson who first proves that he/she is able to perform. This type of letter of credit is popular because it allows a middleperson with limited financial resources to purchase goods from a supplier who only will sell on L/C terms. The middleperson opens the back-to-back L/C, or baby L/C, in favor of the seller for a smaller amount than the master L/C. The difference between the two is the middleperson’s gross profit. Confidentiality is another reason why these instruments are popular. It is possible to deny the name of the original supplier of the goods from the ultimate buyer and vice versa, which protects the middleperson.

In back-to-back L/C operations, the shipping documents tendered by the supplier under the baby L/C usually are used by the middleperson to obtain payment under the master L/C. Documents submitted by the middleperson would normally include the commercial invoice and bill of exchange. The terms and conditions of the baby L/C usually are similar to those of the master L/C.

Standby letters of credit, or more commonly called performance or bid bonds, are very popular in the United States for domestic transactions, and usually are issued for the purpose of guaranteeing payment in the event of non-performance by the applicant. They are becoming more popular in the international arena. Standby L/Cs differ from commercial L/Cs in several ways: the beneficiary’s statement or claim of default suffices to draw funds under the L/C (in contrast to the detailed export documents under commercial L/Cs). This has the effect of making the standby L/C a tangible security as safe as cash. Consequently, the discrepancy rate in standby letters of credit is non-existent. Therefore, any applicant wanting a bank to issue a standby L/C may be asked to collateralize the transaction at 100 percent of face value.

These flexible instruments are useful in many circumstances. For example, they may be used to:

• Support an importer’s frequent, small, open account purchases;
• Cover a brokerage firm’s margin requirement;
• Serve as bid and performance bonds in the construction and service contract industries;
• Cover advance payments and/or performance bonds;
• Provide insurer’s agents worldwide reimbursement of claims paid; or
• Enable corporations issuing commercial paper to obtain a better borrowing rate.

A red clause letter of credit is used to provide the exporter with a portion, or all, of the funds in advance of a shipment. In essence, the red clause extends financing to the exporter prior to shipment, against a simple receipt presented to the issuing bank.

Tips for Using Letters of Credit

Seemingly simple errors will negate an L/C. As a result, it is essential that all the terms and conditions of an L/C be scrutinized closely. In an attempt to eliminate costly errors and ensure that the exporter and importer understand each other, the importer often will issue a proforma letter of credit, which is a draft L/C with all the documents, terms and conditions spelled out. In turn, the exporter should insist that the terms of the L/C are agreed upon before the sales contract is signed. Importantly, a bank with little in-house international experience should consider having an experienced bank scrutinize the L/C.

Upon review of the proforma L/C, all names and addresses, for example, must be spelled correctly. If the exporter’s name and address are misspelled on the L/C, but not on the exporter’s invoice, the issuing bank may deem this as a discrepancy and refuse payment of the documents without referral to the importer. Experience indicates it is well worth the effort to get such minor details ironed out before signing the sales contract.

In addition, shipping dates, presentation periods and L/C expiration dates should all be reviewed carefully to determine whether or not they can be met. Each L/C always will specify a shipment date. If the bill of lading date is not on or before that shipment date, the exporter’s documents will be deemed discrepant by the issuing bank (for late shipment) and the exporter may be denied payment. Of course, it is entirely possible that the importer will accept the date and other discrepancies in order to obtain the documents covering the shipment. It is also true that under the rules for L/Cs, the issuing bank must pay the exporter in the event that shipping documents are released, whether the documents are discrepant or not.

It is also highly recommended that the exporter have a freight forwarder check all the details of the proforma L/C to ensure both the exporter and the freight forwarder understand the implications and can satisfy the documentary requirements. Very often, shipping, insurance, freight forwarding and other fees must be included in the L/C if the importer is to pay these expenses. If not included in the L/C amount, the exporter may be unable to recover the money from the customer.

Documents Against Payment (D/P)

A document against payment (D/P), also referred to as cash against documents, necessitates the use of a sight draft. It is less risky than documents against acceptance, which typically involves a time or date draft. Since a sight draft is a bill of exchange payable immediately upon presentation of the documents, the bill is paid, then the goods are released to the importer.

When using a document against payment, which is similar to a collect-on-delivery (COD) shipment, a downside exists where the buyer has the prerogative to refuse the documents. Should this occur, the goods can sit on the docks and accumulate demurrage charges (fees assessed for freight detained beyond the normal time permitted). The risk of theft also rises. If not claimed, the goods may be moved to a government warehouse where they will accrue warehousing fees. In any event, the exporter would have to arrange and pay for the return of the merchandise, or expeditiously find a second buyer for the goods, probably at a significant discount.

Documents Against Acceptance (D/A)

Documents against acceptance (D/A), also referred to as drafts against documents, bear great risk due to the fact that the seller relies on the buyer’s good intentions to pay for the merchandise after the buyer has possession. This method, however, provides greater documentation than open account since it involves banks as intermediaries. This enhances the seller’s chances of collecting what is owed. The paper trail is similar to that of documents against payment.

In the normal course of events, the exporter will prepare documentation (i.e., commercial invoice, packing lists, bills of lading) proving the merchandise has been shipped, and present it to his/her bank along with the time or date draft. The exporter’s bank will then forward the documents to the importer’s bank. If the exporter wishes, he/she may request that the bank prepare the draft. Upon receipt, the importer’s bank will notify the importer that documents have been presented for collection. If accepted by the importer, he/she acknowledges the stated responsibilities and agrees to abide by the terms. The importer’s bank then releases the documents, allowing the importer clear access to the goods, which would likely be in the possession of the importing broker (not having entered customs). When the funds are due (i.e., in 30 days or on a specific future date), the importer’s bank should receive payment from the importer, then forward the funds to the exporter’s bank, which will pay the exporter.

Open Account

International sales on open account (i.e., payment within 30, 60 or 90 days after receipt of goods) are executed only after long-term relationships have been established between the exporter and importer, or in sales to well-known multinationals. In the case of default, the exporter likely will be forced to file suit in the foreign country. If one is unfamiliar with foreign laws and judicial process, legal proceedings can become very time consuming, expensive and frustrating. Consequently, considerable steps must be taken to ensure the creditworthiness and integrity of the buyer. Nevertheless, honesty may be inconsequential to the importer’s ability to make payment. For example, the importer may have every intention of paying the exporter, but may be incapable due to an unforeseen financial crisis. As a result, the open account method bears tremendous risk to the exporter and only should be contemplated for sales to customers of indubitable standing.

Stated earlier, open account is less risky when export insurance is obtained. Importantly, this not only will protect the exporter and lender up to a designated percentage (i.e., 90 percent of export sale price), but will also allow the international receivables to be added to the borrowing base, essentially becoming an asset.

Consignment

Consignment calls for the importer (who is in possession of the goods, but does not retain title) to pay for the goods when they are legally sold. Because the exporter retains ownership and does not receive payment until the foreign agent or distributor sells the goods, this method carries enormous risk for the exporter. Overall, this method of collection is rarely used in international trade for the following reasons: 1) foreign laws are not always clear about when ownership ends for the U.S. exporter and begins for the foreign importer; 2) it is difficult for the U.S. exporter to track sales thousands of miles away; 3) exchange rates are likely to fluctuate over time, making it difficult for the buyer to meet his/her obligation; and 4) the date of payment to the exporter is not discernible, forcing the exporter to rely on the importer’s word.

Other Payment Mechanisms

Discounting of Drawings Under a Usance Letter of Credit

A usance letter of credit allows the exporter to obtain payment for goods at an earlier date than expressed in the letter of credit. As a result, the exporter may grant the importer more liberal terms (i.e., payment due in 180 days), yet collect payment, at a discount, sooner. This can make a deal much more attractive to the importer while greatly increasing the exporter’s level of international competitiveness.

Upon issuing a usance letter of credit, the issuing bank promises to pay the exporter, against conforming export documents, a certain number of days after sight (after the issuing bank sights the documents, usually 10 days to three weeks), or a specified number of days after the bill of lading date (the date the steamship takes on the goods). From the exporter’s perspective, it is preferred that payment be made a predetermined number of days after the bill of lading date, since this date is easier to ascertain.

Collecting under a usance letter of credit is simple. After shipment, the exporter presents documents per the L/C to the negotiating bank. The negotiating bank will then check the documents carefully to verify that they comply with the L/C terms. If they do, the negotiating bank will advance funds immediately, less the discount representing an interest rate. The exporter will be paid less money than he/she would have collected at maturity, but his/her cash flow will benefit.

Forfaiting

Forfaiting is derived from the French term, “a forfait,” which denotes the surrendering of rights, or when used here, the forfeit of future payments for cash today. It has been used in Europe for more than 30 years. Forfaiting is very popular among the Italians and Germans, and is becoming more familiar to the British, Spanish, and French. It also is becoming more attractive to U.S. and Canadian traders as an alternative method to traditional export trade finance.

Forfaiting is the selling of notes, usually bills of exchange, promissory notes or other negotiable instruments, on a non-recourse basis. In a typical situation, four parties are involved. These include the exporter, the importer, the forfaiting house and the guarantor, which usually involves a bank that may offer the guarantee by using an aval (discussed below). Thus, the exporter transfers payment collection to a third party, the forfaiter, and in turn receives immediate cash, less a fee paid in terms of interest or a discount. The “non-recourse” basis indicates that should the importer fail to pay, the exporter cannot be held liable. An attractive advantage of using forfaiting is the ability to deal with a less complicated negotiable instrument instead of a contract.

Forfaiting is usually used for deals that range from $100,000 - $250,000 on the low end, and not exceeding $8 - $10 million on the high end. Terms commonly range from 1 - 10 years. Both U.S. and European forfaiting houses are active in the U.S. market. To complete the transaction, the forfaiter usually must know the identity of the buyer, the buyer’s nationality, the goods that are being sold, details regarding the contract value and currency used, the date and duration of the contract, the credit period, number of payments and maturity dates, the evidence of debt (usually promissory notes or bills of exchange), and the guarantor’s identity.

Factoring

Factoring is the discounting of a foreign accounts receivable that does not involve a draft. It has been used in the United States to finance domestic sales for decades. Its use in the international arena began in the 1960s, and has become more popular only in the last 15 - 20 years.

When factoring, the exporter transfers title of its foreign accounts receivable to a factoring house (an organization that specializes in the financing of accounts receivable) for cash at a discount from the face value. Factoring products and services, however, are not limited to this. In addition to basic collection services, they offer credit protection and financing. Although factoring is often done without recourse to the exporter, the specific arrangements should be verified by the exporter.

According to Kal Kaplan, Senior Vice President and Project Manager, Current Asset Management Group of Heller Financial, Glendale, California, in 1995, $23 billion in international trade was made possible by international factoring. This represents an increase of 17 percent over 1994. He recommends that when choosing a factoring house, exporters should ensure the house offers complete credit risk protection, an established network of overseas affiliates, an up-front statement of fees, use of experts in the export destination country, and a U.S.-based point of contact to make transactions as convenient as possible.

The Case of ABC Furniture Company

(Provided by James C. Shelley, Vice President and General Manager, International Department, The CIT Group/Commercial Services.)

As explained throughout this publication, export markets offer endless marketing opportunities, but also harbor numerous risks. Unfamiliar languages, laws, and accounting practices make gathering and analyzing credit information difficult, time consuming and costly. In today’s competitive domestic market, however, many manufacturers are finding that in order to expand their customer base and increase their sales volume, it is imperative to look for opportunities abroad.

This was the case for ABC Furniture Company, a $20 million Georgia-based manufacturer of upholstered furniture, established in 1990. ABC entered the global marketplace cautiously and has been exporting goods to Europe for more than three years. Their export sales have grown by 10 percent each year and are currently $1 million annually. This success, coupled with the fact that European customers reacted very favorably toward their products, encouraged ABC to continue to expand its business abroad.

ABC historically restricted sales terms to confirmed letters of credit or cash in advance of shipment. Its local bank had been able to handle the financing of these receivables, but ABC’s European customers complained that the terms of sale were too expensive. Many of its customers told ABC that even though they liked the product, unless more attractive terms were offered, they would discontinue buying more product. As a result, ABC was faced with a situation in which it must offer its customers 60 day terms or risk losing its export business.

ABC had neither the track record nor the confidence in exporting under open account terms. This presented a major problem. The company’s credit department had little experience in evaluating the foreign credit risk, as its expertise was solely in the domestic market. ABC also faced concerns regarding the collection of export invoices and dealing with unfamiliar languages, laws and customs. Additionally, its bank’s policy was not to accept foreign receivables as eligible loan collateral; therefore, the bank would not finance this type of transaction. The bank also lacked experience in evaluating the credit risk of ABC’s foreign customers, whose financial statements were in an unknown language and whose accounting principles differed from those in the U.S. In order to continue growing its export business, ABC and its bank turned to factoring.

Factoring is a complete financial package that combines credit protection, accounts receivable bookkeeping and collections services. It is an agreement between the factor and the seller (the factor’s client) where the factor purchases the seller’s accounts receivable and assumes responsibility for its customers’ financial ability to pay. In the case of ABC, the factor evaluated the credit risk of the foreign customers and established a line of credit for ABC in order to sell to them. It also managed the accounts receivable bookkeeping and collection functions, guaranteed payment on all of ABC’s approved shipments, and paid 100 percent of any bad debts.

ABC assigned its rights to the factoring contract to its bank, so that if a credit loss occurred, the bank’s loan against ABC’s accounts receivable would be protected. This allowed the bank to finance ABC’s receivables, because the U.S.-based factor guaranteed the creditworthiness of ABC’s customers.

ABC and its bank found that factoring best suited their needs. Now that the exporter has a factor managing its foreign accounts receivable, the company is able to focus its attention on its core competency — manufacturing furniture and growing sales — rather than checking credit and collecting receivables. ABC’s bank is pleased with the arrangement because it was able to retain its relationship with ABC and meet the company’s needs for accounts receivable financing.

Avals

Obtaining guarantees on foreign receivables also can be accomplished through the use of an aval draft. This allows the exporter to extend credit with the assurance that he/she will get paid. This instrument, however, does not provide documentary protection. As a result, certain related risks do exist.

Aval drafts can be cost effective and represent an alternative export finance method. Essentially, it is a draft where payment is guaranteed by the importer’s bank through the following steps:

1. The importer draws up a draft declaring that he/she owes the exporter money for goods received, and will pay at a future date.
2. The importer takes the draft to his/her bank and obtains a guarantee confirmed by an official banker’s signature and the term “per aval” stamped on it. The importer then sends the exporter the draft.
3. The exporter obtains a quote from his/her bank on discounting the aval draft. If acceptable, the exporter then delivers the draft to his/her bank for authentication and collection on the due date.
4. Once authenticated, the bank confirms the transaction with the importer’s bank. Then, on the due date, the exporter’s bank pays the exporter, and bears any risk of default by the buyer or his/her bank. The drafts can be discounted, if prearranged.

This appeared as Chapter Two in the book Trade and Finance For Lenders, 1999.