The recent global setbacks caused concern for many, but businesses always rise to the challenge. Many have successfully risen to the challenge by expanding overseas to diversify, spread risk, and increase sales.
This article will look at letter of credit and how your business can benefit from it.
Letter of credit in a nutshell
If your business has an international scope, payment terms can be a significant financial challenge, especially since overseas buyers usually insist on credit periods exceeding 60 or even 90 days. If you need constant raw materials, components, or goods, that term can significantly strain cash flow, mostly if supplier credit periods are strict.
A consequence of the global credit crunch is using secure payment methods like letter of credit, a form of guarantee that transfers the payment risk from a buyer to their bank.
The benefits of using letters of credit for buyers and sellers include:
Even if there’s no relationship with a customer, a letter of credit gives payment assurance from an independent party like the banks, subject to pre-set conditions. It also creates a way to new or potentially difficult markets like unstable economic or political conditions.
Payment is guaranteed after validating documents to the bank. Banks deal in papers and are less concerned with the goods, services, or related exporter performance. The structure of credit comprises timeframes for shipment and document presentation; therefore, the exporter can predict when payment will be affected. The bank may negotiate or discount the value of the documents shown under ‘term’ or ‘usance’ L/Cs.
Stipulates the terms and conditions that lead to an increased likelihood that goods will be received in order and on time while removing the necessity to release cash in advance to the supplier, which minimizes the risk of delayed or non-delivery of delivery the goods.
Stipulating a period for shipment and presentation of documents also leads to cash flow predictability since the importer can be more certain when payment will be activated. By giving the supplier a letter of credit, the bank guarantees payment, and therefore the importer could ask for longer periods of credit to finance the transaction.
Types of Letter of credit and how it works
- Sight Letter of credit
- Usance Letter of credit
- Red Clause Letter of credit
- Transferable letter of credit
- Back-to-Back Letter of credit
- The buyer and seller enter into a contract and agree that payment be made based ona letter of credit
- The buyer approaches the issuing bank to issue a letter of credit in favor of the seller
- The bank issues a Letter of credit which is advised through its branch or correspondent bank (advising bank) in the seller’s country
- Advising bank advises letter of credit to the seller
- Upon receipt of the letter of credit, the seller prepares shipment and delivers documents to presenting bank
- Presenting bank despatches documents to the bank for payment
- The bank pays the presenting bank upon verifying the documents are in order
- Upon receipt of payment, representing bank pays the seller
- Buyer pays the document amount to the bank
- The bank forwards the documents to the buyer, who can now use them to obtain the goods
You can learn more about letter of credit and their practical benefits to your business by visiting a bank website. You can also readily apply for one and get feedback within a day if you visit top bankers in your area.
Whether a supplier asked you to set up a letter of credit or you want your customer to do so, you can activate this option by visiting a bank site and applying online.