What is the difference between LC and cash against documents?

Letters of Credit vs. Cash Against Documents: Navigating International Trade Payment Options

In the complex world of international trade, securing payment can be as challenging as finding the right buyer. Exporters face the inherent risk that a buyer might not pay after receiving goods. To mitigate this risk, various payment methods exist, each offering different levels of security and complexity. Two common methods are Letters of Credit (LCs) and Cash Against Documents (CAD). Understanding the nuanced differences between them is crucial for exporters to choose the option best suited to their individual needs and risk tolerance.

Letters of Credit (LCs): A Fortress of Financial Security

A Letter of Credit is, in essence, a bank’s promise to pay the seller on behalf of the buyer, provided that the seller meets specific conditions and submits the required documentation accurately and on time. Imagine it as a financial shield, protecting the exporter from the potential default of the buyer.

Here’s how it typically works:

1. Agreement: The buyer and seller agree to use an LC as the payment method.
2. Application: The buyer applies to their bank (the issuing bank) for a Letter of Credit.
3. Issuance: The issuing bank, after assessing the buyer’s creditworthiness, issues the LC in favor of the seller (the beneficiary). This LC outlines the terms of payment, including required documents (such as bills of lading, invoices, and inspection certificates).
4. Advising: The issuing bank often uses a correspondent bank in the seller’s country (the advising bank) to authenticate and advise the seller of the LC’s issuance.
5. Shipment & Documentation: The seller ships the goods and prepares all the documents precisely as specified in the LC.
6. Presentation: The seller presents the documents to the advising bank (or directly to the issuing bank, depending on the terms).
7. Payment: If the documents comply exactly with the LC terms, the bank pays the seller. The bank then charges the buyer and releases the documents, allowing the buyer to take possession of the goods.

The key advantage of an LC is its high level of security. The exporter is guaranteed payment by a reputable financial institution, mitigating the risk of non-payment due to the buyer’s insolvency or unwillingness to pay. This is particularly vital when dealing with new customers or trading in volatile markets.

Cash Against Documents (CAD): A Simpler, Yet Riskier, Approach

Cash Against Documents, also known as Documents Against Payment (D/P), is a significantly less complex payment method. In CAD transactions, the exporter ships the goods and prepares the necessary documents, such as the bill of lading, invoice, and packing list. These documents are then sent through banks to the buyer’s bank. The buyer can only obtain these documents (and thus, ownership of the goods) by making payment to their bank.

Here’s the CAD process:

1. Agreement: The buyer and seller agree to use CAD as the payment method.
2. Shipment & Documentation: The seller ships the goods and prepares the documents.
3. Presentation: The seller sends the documents to their bank (the remitting bank), which then forwards them to the buyer’s bank (the collecting bank).
4. Notification: The buyer’s bank notifies the buyer that the documents have arrived.
5. Payment: The buyer pays their bank.
6. Release of Documents: The buyer’s bank releases the documents to the buyer, allowing them to take possession of the goods.
7. Payment to Seller: The buyer’s bank remits the payment to the seller’s bank, which then credits the seller’s account.

While CAD offers a more streamlined and potentially less expensive transaction process than an LC, it also carries a higher degree of risk for the exporter. The buyer is not obligated to pay until they have had the opportunity to inspect the documents (and potentially even the goods, depending on the arrangements). This means the exporter bears the risk that the buyer might refuse to pay, leaving the exporter with the goods in a foreign country and the responsibility for arranging storage, resale, or return shipment.

Key Differences Summarized:

Choosing the Right Method:

The choice between LCs and CAD hinges on the specific circumstances of the transaction.

• LCs are ideal for:
  • High-value transactions
  • First-time business with a buyer
  • Transactions in politically unstable regions
  • Deals where the buyer’s creditworthiness is uncertain
• CAD is suitable for:
  • Transactions with established and trusted customers
  • Lower-value transactions
  • Transactions in stable markets
  • Situations where cost is a primary concern

In conclusion, Letters of Credit and Cash Against Documents represent fundamentally different approaches to securing international trade payments. LCs prioritize security and offer peace of mind for exporters, while CAD offers a simpler and potentially more cost-effective alternative, albeit with a higher risk profile. Thoroughly evaluating the inherent risks and benefits of each method, in relation to the specific trade context, is crucial for exporters to make informed decisions and protect their financial interests.