Documentary Collection or Draft is the term when you ship the goods before the payment is made and then draw a draft on the buyer, not on the bank, like under L/C. Under documentary collections banks have no responsibility for the payment.
There are two types of documentary collections - sight draft, also know as "Documents Against Payment", and time draft, also known as "Documents Against Acceptance".
"Sight draft" is payable by the buyer immediately after notification by the buyer's bank of the receipt of the draft and transport documents.
Under this method of payment you (the Drawer) negotiate the terms with the buyer (the Drawee), specify the documents required for the payment, ship the goods and draw the draft on the buyer. The draft and the documents required for the payment are presented to your bank (Remitting Bank) and after examination are forwarded to the buyer's bank (Presenting Bank). The Presenting Bank holds the title documents (usually the transport documents) and will release them to the buyer only after the payment was made.
Sight draft procedure is shown in the diagram below: Sight draft procedure
1. The Drawer and the Drawee negotiate terms and conditions of the transaction
2. The Drawer ships the goods
3. The Drawer draws a draft and presents it to the Remitting Bank along with other documents
4. The Remitting Bank examines the documents and the draft and forwards them to the Presenting Bank
5. The Presenting Bank notifies the Drawee of receipt of the documents
6. The Presenting Bank holds the documents until the payment is made by the Drawee
7. The Drawee examines the documents and makes the payment for the supplied goods
8. The Presenting Bank releases the documents to the Drawee
Sight drafts have some similarity with L/C. You deal with documents and through banks, and the buyer cannot take the possession of the goods before the payment is occurred.
However, the payment is not guaranteed. If the buyer for any reason refuses to pay, you have to deal with goods "on the water" or stacked in the customs zone in a foreign country. It can be very costly to ship your goods back or to sell them urgently. In both cases, there are substantial additional expenses (warehousing, cost of transportation to a new destination, significant discount, etc.). In some cases, the buyer who failed to pay was one of the bidders at the resulting auction and had bought the goods for a fraction of the initial price.
It is also possible, that the buyer will delay the payment. Although legally the payment has to be made immediately upon receipt of the draft by the buyer's bank, the buyer may hold the payment until the goods are delivered.
Unlike the sight draft, when dealing with time drafts, the buyer may take possession of the goods before the payment. Under the time draft, you agree on a deferring period, ship the goods and draw a draft. For the title documents to be released, the buyer has to accept the draft by issuing written evidence of his willingness to pay on the agreed maturity date (usually by signing and dating the draft).
Dealing with the 'time draft', always draw a draft against the certain date specified in the other document. (For example, "Payable at 60 days after invoice date/bill of lading date/the draft date")
The time draft, in fact, is very similar to "open account" terms – you have no control over the goods, nor over the payment. The only difference is that, in addition to the contract of sale, you have the buyer's written guarantee to make a payment on a certain date. You have to rely on the buyer. The consequences of the refusal to pay are the same as the
consequences of the refusal to pay under "open account" (see below).
Drafts are normally issued in a set of two (First of Exchange and Second of Exchange) or singly (Sola Bill of Exchange). ) Two drafts are usually drawn to ensure that at least one draft reaches the Drawee when they are dispatched separately. When two drafts are issued they may be numbered "1" and "2" and marked "First of Exchange (Second
Unpaid)" and "Second of Exchange (First Unpaid)".
Documentary collection is cheaper then L/C but the risk involved is much greater, especially with the time draft. I wouldn't recommend these terms, unless you are dealing with a well-known trusted buyer or the transaction is insured.