What it means
A draft, also called a bill of exchange, is a document in which one party, the drawer, orders another party, the drawee, to pay a sum to a third party. In a sight draft the payment falls due the moment the drawee sees it.
This contrasts with a time draft, which is payable after a set period such as 60 or 90 days. In practice, an exporter ships goods and gives the shipping documents and the sight draft to its bank.
The bank forwards them to the buyer's bank, which presents the draft to the buyer. The buyer pays and receives the documents needed to collect the goods, such as the bill of lading, which is the transport document that proves ownership of the cargo.
This arrangement is called documents against payment. It protects the seller because the buyer cannot take the goods without paying, and it protects the buyer because payment is made only when the correct documents arrive.
It is cheaper than a letter of credit but offers less security, since there is no bank promise to pay if the buyer refuses. Sight drafts also appear under letters of credit, where the bank agrees to pay on sight once the seller presents compliant documents.
In that case the bank, not the buyer, is the party who pays, which greatly reduces the seller's risk. The seller still has to make sure the documents match the credit terms exactly.
The main risks are that the buyer refuses to pay or delays after the goods have arrived at the port. Storage fees can build up, and the seller may have to find another buyer or ship the goods back.
For this reason sellers usually check the buyer's creditworthiness before using a sight draft.
In practice
Real-world examples.
Example
A coffee roaster in Colombia ships $120,000 of beans to a distributor in Germany and asks her bank to send a sight draft with the shipping papers. The distributor pays when the draft is presented and receives the documents. The roaster is paid before the cargo is released.
Example
A furniture factory in Vietnam sells $60,000 of chairs to a new customer in Canada. Because it has no credit history with the buyer, the factory uses a sight draft rather than offering 60 days of credit. The buyer pays on presentation and collects the goods.
Example
A medical equipment supplier sells to a hospital group under a letter of credit that calls for payment at sight. The supplier presents the documents to the issuing bank and is paid within days. A mistake in the invoice date delays the payment by a week until it is corrected.
Formula
Calculation
Net proceeds to the exporter = draft face amount - bank collection charges
Suppose an exporter ships machinery and draws a sight draft for $80,000. The exporter's bank charges $400 to handle the collection, and the buyer's bank takes another $150. The net proceeds are 80,000 - 400 - 150 = $79,450. The buyer pays the full $80,000 on presentation, and the exporter receives the money a few days later after the banks process it.Case study
Seen in the real world.
Tallis Spices is an illustrative, fictional exporter that sold $90,000 of spices to a new importer overseas. The importer asked for 90 days of credit, but Tallis had no information on its finances.
The finance manager offered a sight draft instead, with the bank holding the shipping documents until the importer paid. The importer agreed, paid within four days of the cargo arriving and collected the goods.
The exporter received its money three months earlier than it would have under the importer's proposal, which cut its need for short-term borrowing. The illustrative lesson is that a sight draft can be a simple way to trade with a new customer without taking on credit risk.
Watch out
Common mistakes.
- Assuming a sight draft guarantees payment, when without a bank undertaking the buyer can still refuse to pay.
- Releasing shipping documents to the buyer before payment, which removes the seller's control over the goods.
- Forgetting storage and demurrage costs that build up at the port if the buyer is slow to pay.
Questions
People also ask.
What is the difference between a sight draft and a time draft?
A sight draft is payable immediately on presentation, while a time draft is payable after a stated period, such as 60 days.
Who is the drawer and who is the drawee?
The drawer is the party who issues the draft, usually the seller, and the drawee is the party who must pay, usually the buyer or a bank.
Is a sight draft the same as a letter of credit?
No, a sight draft is a payment order, while a letter of credit is a bank's promise to pay, and the two are often used together.
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