A letter of credit (LoC) is a method of minimising risk to sellers trading internationally by guaranteeing they will be paid for their goods, as long as certain agreed conditions are met. The buyer asks his bank to set up a letter of credit, this can only be done if the buyer has the money in their account or they have the banking facility to cover the cost and payment. The buyer’s bank then sends the letter of credit to the seller’s bank who then passes this to the buyer. In some circumstances the seller may ask their bank to seek a ‘confirmation’ of the letter of credit which adds another bank to the process but does provide additional security to the payment, this reflects on the buyer’s bank rating or market conditions.
As stated above, a letter of credit only guarantees payment if the terms within it have been met. These will obviously vary, depending on the contract agreed, but will require that the quoted documents usually the document of title in shipping or certification of carriage in other modes of transport are presented on time and in order.
This is a greater exercise of accuracy than many businesses exporting their goods appreciate, especially when new to exporting. Documents must be in strict accordance with the terms set out in the letter of credit. If the terms are not met, the bank will not issue payment in the event that the buyer fails to pay. It is therefore very important that sellers read the letters of credit carefully before agreeing to them and ensure that their documentation matches what is being demanded to the letter, yes even misspelled words.
There are advantages to both seller and buyer because letters of credit reduce risk for both. For the seller it provides a guarantee of payment (as long as the conditions are met). For the buyer it means they don’t have to pay for goods until they have been received and that they will be documented properly.
Given that letters of credit offer a great advantage in managing risk for both parties, it would appear to be the perfect solution. However, there are costs involved to both applicant (buyer) and beneficiary (seller). Therefore, it is important to understand the scale of these charges (usually a percentage of the invoice) and ensure that they have been accounted for in your costing.
While a letter of credit minimises risk, it doesn’t eradicate it and you still need to be aware of common pitfalls, including those below:
Letters of credit can be complex and inevitably sometimes amendments will have to be made, if you find that you are unable to meet the terms set out in the original LoC. If this happens, you must first communicate quickly the changes needed to your buyer and ask them to agree to new terms. If they agree, you will need to inform your bank (the advising bank) and then they will contact the buyer’s bank (the issuing bank) to seek authority to amend the credit. Be warned though, this will incur further charges so it’s much better to ensure the original LoC is accurate.
Letters of credit remain a common way to guarantee payment in international trade, due to the protections they afford. However, you should also consider alternatives such as advance payment, invoice factoring, trade credit insurance or our Small Business Vaults.
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