Cash Against Documents Vs. Letter of Credit

by Sara Huter, Demand Media
    Cash against documents and letters of credit are used to secure payment for the shipment of products.

    Cash against documents and letters of credit are used to secure payment for the shipment of products.

    When doing business internationally, many vendors protect their interests by asking customers to pay by "cash against documents" or with a "letter of credit." Both are forms of payment that guarantee payment after the product is delivered.

    Cash Against Documents

    A cash against documents (CAD) transaction is one in which the seller retains ownership of the product until payment is made. The documents that specify the terms of the transaction are held by an intermediary, most often a bank, agreeable to both the buyer and seller. Once payment is remitted, the bank releases the documents showing that the buyer can take ownership of the product. CAD transactions are most often used for international transactions in which an open trade account is not possible because the buyer is unfamiliar to the seller or the buyer’s credit standing may not meet the sellers criteria.

    Letter of Credit

    A letter of credit (LC) is a formal letter from the buyer’s bank to the seller indicating the bank's financial support of the buyer. The LC authorizes the seller to demand payment from the bank if the seller fails to pay. Like cash against documents transactions, an LC is used when the seller is unwilling to offer open trade credit, often in international transactions. Businesses usually allow customers to buy using a credit line, called trade credit in business-to-business relationships, whereby the customer buys the product and pays 10 to 30 days later. Some LCs are used for a single transaction, while others take the place of trade credit when the buyer plans to make regular purchases from the seller.

    Advantages and Disadvantages of CAD Transactions

    For both buyer and seller, the most convenient arrangement for doing business is through trade credit. However, trade credit is not possible if the seller believes the buyer is a high-risk candidate for payment default.
    The primary advantage of a CAD transaction is for the buyer. A CAD transaction is less expensive for a buyer than an LC and it does not tie up financing as an LC might. A CAD is riskier for the seller if the buyer refuses delivery and the seller does not receive payment. At this point, the buyer must pay to have the product transported back to the origination point.

    Advantages and Disadvantages of LC Transactions

    The primary advantage of an LC transaction is for the seller. Even if the buyer refuses delivery, the seller can still get payment for transportation and other expenses. An LC ties up the buyer’s bank line of credit, which could be used to pay other vendors. In some cases, the bank may require a cash deposit from he buyer to secure the amount of the LC.

    About the Author

    Sara Huter is a professor of economics. Her background also includes risk management in the banking and energy industries with expertise in credit scores. Huter received an M.B.A. in finance from Texas A&M University and a B.S. in information systems from Kansas State University. She has been writing for over five years with work at Popsyndicate.com, WickedWordSmith.com and Simplejoy.com.

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