Financial risk considerations when entering into sales contracts

Financial risk considerations when entering into sales contracts

In connection with bidding and entering into sales contracts there is – besides the scope itself – a number of different matters to consider

MWA Themes #1 Financial risk considerations when entering into sales contracts

MWA Themes are short articles on various topics with a focus on what is most important for you as an exporter or importer. This doesn’t mean that other factors are not important. There are several “product-technical” features to deal with, just as there will specific considerations in relation to the commercial contract.

In connection with bidding and entering into sales contracts there is – besides the scope itself – a number of different matters to consider, e.g. market conditions, competition, logistics, insurance, taxation, legal- and financial matters.

The following will discuss financial matters only – credit risk, liquidity risk and currency risk – with focus on seller’s interests, and preferences and disregarding other matters incl. tendering conditions and competitive situation etc. Real life is of course more complex, but the intention here is to create awareness of various financial risks and challenges that seller should be aware of when negotiating contracts.

Credit risk

The most important question: Is the buyer able and willing to pay ?

Fortunately, most buyers are both able and willing to pay – i.e. the so-called commercial risk is limited. Further, if the buyer’s home country is politically, socially and economically stable, then the country risk – the so-called political risk – is also limited.

In situations where the commercial and/or political risk is higher than the seller is willing to accept, he may, as a going-in position, insist on security for payment. Payment security can take many different forms, the most common of which are:

-advance payment
-letter of credit
-bank guarantee

It applies to all three types of payment security that they will only have real value to the seller if they are irrevocable.

For example, if – in return for an advance payment – seller has to provide an advance payment guarantee which is payable on first demand (which is a very common occurrence), then the advance payment cannot be considered a security for payment. The reason for that is that the buyer can reclaim the payment under the guarantee whether or not such claim is justified. If it is not justified, there will of course be a legal dispute, but worst case is that the money is lost.

For letters of credit and bank guarantees it applies that – besides being irrevocable – they have to fulfil certain formal requirements, be issued on acceptable terms and conditions and be issued or confirmed (re-guaranteed) by a bank an bank acceptable to the seller.

So, the seller will not necessarily have any real security for payment just because he has received a prepayment, a letter of credit or a bank guarantee. It is absolutely crucial for the real value of any payment security that – at least on the key points – it is appropriately structured.

Obviously, not all preferences can be accommodated at all times. In any case, however, it is important to be aware what kind of risks you face if you relax the requirement for payment security. And it is equally important to know how risks can be mitigated and what the cost will be for this.

As an alternative to the buyer providing security or paying in advance, it will often be possible to take out credit insurance. It typically covers commercial and political risks for 90% of the insured amount The possibility to take out credit insurance depends on the credit insurance company’s assessment of the buyer’s creditworthiness and their assessment of the country risk. And the same goes for the pricing.

Liquidity risk

Overall, you must have a positive cash-flow so that you are at all times you are able to meet your payment obligations on time.

Each contract should therefore always, as a starting point, have a positive cash-flow throughout its lifetime. There may be exceptions in special cases, but keep in mind that even if periods with negative cash-flow are compensated for (e.g. via higher price or interest), it neither improves working capital nor the ability to meet payment obligations on time.

Even if you have a solid financial buffer, you should generally avoid becoming a de facto lender to your customers by providing credit beyond what is industry standard. If a customer needs financing, you can possibly assist in arranging this, e.g. in the form of an export credit or otherwise.

And if you are under strong pressure to offer very long credit (= provide loans) then there are also ways to do this while you yourself get cash payment – but of course it comes with a cost, and that cost must then be added to the contract price.

Currency risk

When bidding and entering into contracts in foreign currency, you assume a currency risk.

It is relatively straightforward to hedge such risk during the contract period, e.g. via netting, forward contract(s) or a combination of the two.

But if you have to assume the currency risk during the bidding period because you have to keep an offer open at a fixed price in foreign currency for a longer period, then it is a different situation. You don’t know whether or not you will win the contract, and thus you cannot use forward contracts.

If possible, you can instead make reservations for currency depreciation during the bidding period. The buyer will then typically demand that it also applies the other way around. As such, this is fair enough, and if it is possible to agree on a currency adjustment clause on this basis, then it is definitely useful solution.

Alternatively – if the buyer insists on a fixed price offer in a foreign currency – currency options or variants thereof could be considered. However, this requires either that you tolerate a certain fluctuation, or that you are ready to pay for a currency option – without any certainty that you will actually end up with a contract that can contribute to cover this cost.

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