Fees, financing and expected loss priced for both instruments on one export order, and the buyer default rate at which the answer flips.
A documentary collection costs about half what a letter of credit does in bank fees, but it leaves the buyer's default risk with the exporter. On an illustrative 4,200,000 order on 90-day terms, the collection costs 136,252 all in and a confirmed usance credit 115,337. The credit is cheaper whenever the buyer's default probability over the tenor exceeds 0.67 per cent.
Worked in full in Trade Finance by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
The comparison usually made is the fee schedule, and on fees the collection always wins. But the two instruments do not buy the same thing. Under a collection the banks move documents and nothing else; under a confirmed credit a bank in the exporter's own market promises to pay against compliant documents. The fair comparison prices fees, the financing of the days to cash, and the expected loss each route leaves behind.
| Input | Collection (D/A 90 days) | Confirmed usance credit |
|---|---|---|
| Price | 4,200,000 | 4,200,000 |
| Cost of goods sold, financed at 8.4% a year | 3,423,000 | 3,423,000 |
| Days from shipment to cash | 106 | 104 |
| Remitting bank commission | 0.15% | none |
| Collecting bank charges, for the exporter's account | 0.20% | none |
| Courier and messages / advising | 250 | 350 |
| Confirmation, per quarter or part, 2 quarters | none | 0.30% |
| Document examination | none | 0.125% |
| Discrepancy fee 150, probability of discrepant documents | none | 60% |
| Risk left with the exporter | buyer: 1.5% default, 60% loss | documents: 3.0% refused, 2.0% cost |
Financing is charged on the cost of goods, not on the price, because what the exporter funds until it is paid is its own outlay. The days differ by two because the collection adds a few days of mailing and acceptance that the credit's presentation does not.
=(LCtot-ColFees-ColFin)/(Price*LGD).| Line | Collection | Confirmed credit |
|---|---|---|
| Bank fees | 14,950 | 30,890 |
| Financing of the days to cash | 83,502 | 81,927 |
| Expected loss | 37,800 | 2,520 |
| Total | 136,252 | 115,337 |
| Share of price | 3.24% | 2.75% |
The credit's fees are 2.07 times the collection's, 15,940 more. It saves 35,280 of expected loss and a little financing, and ends 20,916 cheaper. Against the order's operating margin of 306,600, the collection leaves 170,348 and the credit 191,263.
Solving for the buyer risk that makes the two equal: (115,337 − 14,950 − 83,502) ÷ 2,520,000 = 0.67 per cent. A buyer whose probability of default between shipment and payment is below that is cheaper to sell to on a collection. Above it, the credit is.
The buyer default probability is the input that decides the answer and the one most exporters never write down. Rating agency default tables, credit insurer limits and your own payment history with the buyer are the places to look. If the honest answer is “we don't know”, the 0.67 per cent is the question to ask: is this buyer safer than that?
| Buyer default probability | Collection | Confirmed credit | Collection minus credit | Cheaper |
|---|---|---|---|---|
| 0.25% | 104,752 | 115,337 | −10,584 | collection |
| 0.50% | 111,052 | 115,337 | −4,284 | collection |
| 0.67% | 115,337 | 115,337 | 0 | either |
| 1.00% | 123,652 | 115,337 | 8,316 | credit |
| 1.50% | 136,252 | 115,337 | 20,916 | credit |
| 3.00% | 174,052 | 115,337 | 58,716 | credit |
The confirmation is 82 per cent of the credit's fees, so it is the input that moves the break-even most: every 0.10 per cent a quarter shifts it by 0.33 points of buyer default probability. At 0.15 per cent a quarter the credit wins above 0.17 per cent buyer risk; at 0.50 per cent a quarter it needs 1.34 per cent, at 0.75 per cent a quarter 2.17 per cent. A confirmation is priced on the issuing bank and its country, not on your buyer, which is why a weak buyer in a strong banking market is where the credit earns its fee. Whether to confirm at all is a separate decision, worked in whether a letter of credit confirmation is worth paying for.
Comparing fee schedules only. On fees the collection is half the price and always looks right. The instrument that costs less in fees costs more in risk, and the risk line is the largest difference in the table.
Treating documents against acceptance as secured. Under D/A the buyer takes the documents, and the goods, against a signed draft. If the draft is not paid at maturity, the exporter holds a claim on the buyer and nothing else. Documents against payment keeps control of the goods until payment but gives the buyer no credit period.
Assuming a credit carries no risk. A confirmed credit pays only against compliant documents. Discrepancies are common, and a refusal the buyer will not waive turns the credit back into a collection. That is the 2,520 in the table, small but not zero.
The fee rates above are illustrative, chosen to show the method; the book prices the same order on its own schedule, so its totals differ. All six routes to payment on this order, at the same 90 days, are priced in the free workbook for this case, with the fee schedule, cost of funds and risk inputs in blue cells.
In fees, yes: on the 4,200,000 order 14,950 against 30,890 for a confirmed usance credit, about half. All in, it depends on the buyer. With a 1.5 per cent default probability and 60 per cent loss given default, the collection carries 37,800 of expected loss and costs 136,252, against 115,337 for the credit.
Non-payment. The banks handle documents, not credit risk: under documents against acceptance the buyer takes the goods on signing a draft and may still not pay at maturity. The exporter keeps the buyer's default risk in full, which is why the comparison with a letter of credit has to include expected loss, not only fees.
Directly, because it is most of the credit's fee stack. At 0.15 per cent a quarter the letter of credit wins above a 0.17 per cent buyer default probability; at the base 0.30 per cent above 0.67 per cent; at 0.75 per cent a quarter the buyer has to be riskier than 2.17 per cent before the credit pays.
This article is one calculation from Trade Finance. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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