A letter of credit is a financial instrument used to secure payment to a specified party on production of specified documents that evidence the shipment of goods. Letters of credit are typically required by overseas suppliers in an attempt to mitigate some of the risks associated with trading on open account terms.
Although they can also be used in trade within one company in some circumstances. The letter of credit also gives some element of reassurance to the buyer that they will not be payment for product that has not been shipped or does not meet the terms of their order.
The letter of credit is issued by a bank and will typically name the business that will be the beneficiary (typically the supplier), specify the documents that are required to be presented (see below), specify the sum to be paid and the expiry date of the letter of credit (often abbreviated to an LC).
The documents required by the LC are normally those required to evidence shipment of the goods and the quality and quantity of the product that has been shipped. Letters of credit are not only relevant to sea transportation, they can be equally be used for air and road transported goods.
Typically the LC may call for documents that evidence the packing of the goods, known as a packing list. Multiple copies of documents may be required by the LC. Invoices are also typically required. The buyer may call for some form of inspection certification. This may be by an independent inspectorate such as a government department or it may be by the buyers overseas agent. The former may be required for the importation of the product e.g. compliance with safety standards and the latter can be required to give the buyer more assurance that the product is fit for purpose and of merchantable quality.
Next the LC is likely to call for documentation that evidences the shipment of the product. For sea freight this may be bills of lading. A bill of lading is a document issued by a shipping company evidencing the receipt of goods (normally in containers) onto a specified ship for onward transfer to a specified destination. For air freight, an airway bill is typically required, providing similar evidence of loading onto a plane. In the case of transport by road, documents evidencing road transportation will be requested.
The letter of credit could make request for other documents in addition to the above. The LC will confirm that on presentation of these documents to a bank, the specified sum will be paid.
Despite the added security of trading by letter of credit there are still some risks to the supplier if funds are not available from the issuing bank to clear the LC. Therefore, in some cases the seller may ask for the letter of credit to be confirmed by a local bank. In confirming a letter of credit, the local bank undertakes to pay the LC and takes on the financial risk.
Letters of credit can therefore be useful to the buyer and the seller but the buyer will need to either provide funds to their bank or have a facility in order to open a letter of credit to their supplier. This can create an issue for the buyer. This can be addressed in a number of ways. Firstly, if the buyers credit standing is good they may quality for a revolving facility which can be used to open letters of credit to their suppliers. If the buyers credit history is not so strong they may be able to use a factoring facility, combined with a trade finance facility to secure the transaction. In the case of factoring, the factoring company will factor the ultimate debts to the buyers debtors and the funds released from these sales invoices are used to liquidate the liability incurred from the letter of credit.
Similar to a letter of credit is a documentary collection. With this form of payment, a local bank will be instructed to pay the buyer of production of specified documents in much the same way as a letter of credit. However, the sellers security is reduced as the exact requirements are not set out and agreed in a financial instrument as is the case with a letter of credit.
Letters of credit, documentary collections, trade finance and factoring are complicated areas, especially when concerned with imports and exports. However, our advisers will be more than happy to assist you by finding you organisations that can open letter of credit for you and if necessary provide the trade finance and factoring facilities to support the opening of letters of credit to your suppliers.
The cost of letter of credit, trade finance facilities depends very much upon your requirements and circumstances.