What it means
Three parties are involved in a bill of exchange. The drawer writes it and is usually the seller, the drawee is the customer ordered to pay, and the payee is whoever receives the money, which may be the drawer or a bank that has bought the bill.
The bill only becomes a firm obligation when the drawee accepts it, normally by signing across the face of the document. An accepted bill is far easier to sell or borrow against than an ordinary invoice, because acceptance is a formal admission that the debt is owed.
Its usefulness lies in timing. A seller who has agreed 90 day payment terms does not have to wait 90 days for cash, because the accepted bill can be discounted with a bank that pays out the face value less a charge and collects from the customer at maturity.
Bills of exchange are common in international trade, often alongside a letter of credit. A documentary collection routes the bill and the shipping documents through the banking system, so the buyer only receives the paperwork needed to collect the goods once the bill has been paid or accepted.
The main risk is dishonour, meaning the drawee fails to pay at maturity. Discounting is usually done with recourse, so if the customer defaults the bank can reclaim the money from the seller, which is why a discounted bill does not necessarily remove the credit risk.
In practice
Real-world examples
Example 1
A machinery exporter ships $250,000 of equipment and draws a 90 day bill on the buyer. The buyer's bank accepts the bill, which converts a corporate risk into a bank risk, and the exporter discounts it straight away to fund the next production run.
Example 2
A commodity trader uses a documentary collection so the buyer cannot take delivery of a coffee shipment until it accepts a 60 day bill. The bill gives the trader an enforceable instrument rather than an open invoice if the buyer later disputes the quality.
Example 3
A textile importer accepts three bills of $80,000 each, maturing at 30, 60 and 90 days, to spread the cost of a single shipment. The supplier discounts all three at once and receives cash up front while the importer preserves its own working capital.
Think of it
A bill of exchange is like an official, written IOU that has been notarised. Instead of just a handshake and a promise to pay next month, you have a formal paper trail that everyone agrees is legally binding.
Formula
Calculation
Discount charge = face value x annual discount rate x (days to maturity / 360)
Proceeds = face value - discount charge
An exporter draws a bill of exchange on a customer for $250,000 payable 90 days after sight, and the customer accepts it. Rather than wait, the exporter takes the accepted bill to its bank, which discounts it at 8% a year on the common 360 day convention.
The discount charge is $250,000 x 0.08 x (90 / 360) = $250,000 x 0.02 = $5,000, so the exporter receives $250,000 - $5,000 = $245,000 today and the bank collects the full $250,000 at maturity. In effect the exporter has paid $5,000 to convert a 90 day promise into cash, a charge of $5,000 / $245,000 = 2.04% over the three months.Case study
Seen in the real world
The following is an illustrative and fictional example. Corveth Ceramics, an invented tile manufacturer, sold $600,000 of stock to an overseas distributor on extended terms and drew four bills of exchange of $150,000 each, maturing at 30, 60, 90 and 120 days, all of which the distributor accepted.
Needing cash for its own suppliers, Corveth discounted the bills as soon as they were accepted. On the 90 day bill the charge was $150,000 x 0.09 x (90 / 360) = $3,375, so the company received $150,000 - $3,375 = $146,625, and the other three were discounted on similar terms.
The 120 day bill was then dishonoured when the distributor ran into trouble. Because the discounting had been arranged with recourse, the bank simply reclaimed the full $150,000 from Corveth, and the fictional finance director's conclusion was that bills of exchange had improved the timing of the cash without ever transferring the credit risk.
Watch out
Common mistakes
- Confusing a bill of exchange with an invoice, when an invoice requests payment and a bill is an order to pay that becomes binding on acceptance.
- Assuming that discounting a bill removes the credit risk, when most arrangements give the bank recourse to the seller if the customer fails to pay.
- Treating the discount charge as a fee rather than as interest, which hides the real annual cost of the funding from the people approving it.
Questions
People also ask
What is the difference between a bill of exchange and a promissory note?
A bill is an order by the seller telling the buyer to pay, while a promissory note is the buyer's own written promise to pay.
What does accepting a bill actually mean?
It means the drawee signs the document to confirm the debt, turning the bill into a binding obligation that can be traded or discounted.
Are bills of exchange still used?
Yes, particularly in international trade and in markets where documentary collections remain standard, although open account trading and electronic invoice finance have taken much of the domestic volume.