Letter of credit or cash against documents: choosing the right payment term

In international trade, the buyer wants the goods before paying and the seller wants to be paid before letting the goods go. Payment terms are how the two sides meet in the middle. For chemical and commodity shipments, two instruments come up again and again: the letter of credit (L/C) and cash against documents (CAD), also called a documentary collection.

Both rely on the same idea: the shipping documents, above all the bill of lading, control access to the cargo, and they only reach the buyer against payment or a bank commitment. But the level of security, the cost and the paperwork are quite different.

How a letter of credit works

A letter of credit is a written undertaking by the buyer's bank (the issuing bank) to pay the seller, provided the seller presents documents that comply exactly with the terms of the credit. Most L/Cs are governed by the ICC's Uniform Customs and Practice for Documentary Credits, UCP 600.

The typical sequence:

1. Buyer and seller agree the contract, including L/C payment.
2. The buyer asks its bank to issue the L/C in favour of the seller.
3. The L/C is advised to the seller through a bank in the seller's country. That bank may also confirm it, adding its own payment undertaking.
4. The seller ships and presents the required documents to the bank.
5. The banks check the documents against the L/C. If they comply, payment is made, either at sight or at a later date for a usance L/C.
6. The documents are released to the buyer, who uses them to collect the goods.

The key point is that banks deal in documents, not goods. They do not inspect the cargo. They check whether the paperwork matches the credit, word for word where required.

How cash against documents works

With cash against documents, the seller ships the goods and sends the documents through its bank to a bank in the buyer's country (the collecting bank), with instructions to release them only against payment (D/P, documents against payment). A variant, D/A (documents against acceptance), releases them against the buyer's acceptance of a bill of exchange payable later.

Collections are governed by the ICC's Uniform Rules for Collections, URC 522.

Here, the banks act as intermediaries only. They do not guarantee payment. If the buyer does not pay, the documents stay with the collecting bank, and the seller still controls the goods, but they are sitting in a foreign port.

Comparing the two

Security for the seller. An L/C gives the seller a bank's payment undertaking, and a confirmed L/C adds a second one. CAD depends on the buyer's willingness and ability to pay when the goods arrive.

Security for the buyer. Under both, the buyer pays against documents, not after inspecting the goods. An L/C lets the buyer require specific documents, such as an independent inspection certificate or a certificate of analysis, as a condition of payment. That gives some control over quality and quantity.

Cost. L/Cs involve issuing, advising, possibly confirming, and amendment fees, and they may use up part of the buyer's credit lines with its bank. Collections are usually cheaper and simpler.

Paperwork and timing. L/Cs demand precise documents. A misspelt name or a date outside the credit can cause a discrepancy, delaying payment or costing fees. Collections are more forgiving on form.

Speed of access to goods. With both, the buyer needs the documents to clear the cargo. Delays in the banking chain can lead to demurrage at the port, so it pays to choose efficient banks and courier routes.

Which one to choose

There is no universal answer. The right choice depends on:

• The relationship. For a first transaction, or a large one, an L/C protects both sides while trust is built. With an established partner, CAD is often enough.
• Country risk. Where foreign exchange availability or political risk is a concern, sellers often ask for a confirmed L/C.
• Regulations. Some countries require an L/C, or a specific form of payment, for certain imports. Check local rules before agreeing terms.
• Cost of the goods and cash flow. A usance L/C or D/A can give the buyer time to sell the goods before paying, at a financing cost.

Practical tips for a smooth L/C

• Send the seller a draft of the L/C before it is issued, so documents can be agreed in advance.
• Keep the description of goods short and identical to the contract.
• Allow realistic dates for shipment and presentation.
• Avoid documents that the seller cannot control, such as certificates signed by the buyer.
• Make sure the Incoterm in the L/C matches the one in the contract.

How Dhow Group handles this

We work with confirmed and unconfirmed letters of credit, cash against documents and, where our credit insurance allows, [open-account terms]. Before an L/C is issued, our team reviews the draft with you to remove clauses that could cause discrepancies, and we prepare every document to match the credit. The aim is simple: you receive the documents on time, and the goods clear without surprises. Learn more about our trade finance service.