Letter of Credit: What Is It and How Does It Benefit Your Business?

In domestic business transactions, the process is usually clear-cut. Sellers assess the credit history of their buyers, deliver goods, and issue invoices. If a buyer fails to pay, the seller can pursue legal action. The same can’t be said about international trade, where the risks are higher and more complex. For sellers, the primary concern is the risk of non-payment after shipping goods, coupled with the challenges of pursuing legal action across countries with varying legal systems. On the buyers’ side, the risks include making advance payments without receiving the goods or getting goods that don’t meet their expected standards. In this context, a letter of credit (LC) emerges as a critical tool to mitigate these risks for importers and exporters.

Key Takeaways of a Letter of Credit

Key Point	Description
What Is a Letter of Credit?	A letter of credit is a contractual commitment by a buyer’s bank to pay the exporter or seller once the goods are shipped & the required documentation is presented.
Essential Parties to a Letter of Credit	The key parties involved in a letter-of-credit transaction in trade finance include the buyer, seller, issuing bank and confirmer.
The Benefits of a Letter of Credit	Key benefits of a letter of credit include access to new business opportunities, defined shipment deadlines, customisable payment terms & more.
Payment Execution in a Letter-of-Credit Transaction	In an LC arrangement, the payment release hinges upon fulfilling specific conditions outlined by the buyer through the issuing bank or third-party financier.
Types of Letters of Credit	A letter of credit comes in various forms, each tailored to specific transactional needs.

What Is a Letter of Credit?

A letter of credit is a contractual commitment by a buyer’s bank to pay the exporter or seller once the goods are shipped & the required documentation is presented.

It is designed to protect both suppliers and buyers in international trade, offering a guarantee of payment to the exporter while providing reasonable payment terms to the importer. Settlement for the buyer can be at sight or a term from 30 to 180 days. They can even stipulate payment terms according to their cash flow requirements.

Essential Parties to a Letter of Credit

The key parties involved in a letter-of-credit transaction in trade finance include:

Applicant or Buyer:

This is the party purchasing goods or services, known as the buyer. In the context of an LC, they are also referred to as the applicant. They request their bank to issue a letter of credit, which acts as a legal document guaranteeing payment to the seller or exporter.

Beneficiary or Seller:

The seller is the individual or entity offering goods or services in exchange for payment. In trade finance, they are central to the origination of invoices and receivables. Under a letter of credit, the seller or beneficiary is assured of receiving payment as per the agreement.

Issuing Bank or Financier:

This is the financial institution that issues the letter of credit at the request of the buyer. It undertakes the responsibility of ensuring payment to the seller, thereby facilitating the transaction.

Confirming Bank or Confirmer:

The confirmer is involved when the exporter seeks additional assurance beyond what the issuing bank provides. It agrees to assume the obligations of the issuing bank, adding an extra layer of security to the transaction.

The Benefits of a Letter of Credit

The buyers primarily benefit from an LC. Key benefits of a letter of credit include:

Access to New Business Opportunities:

An LC can be instrumental in establishing trust with new suppliers, especially those who might be hesitant to engage in business due to unfamiliarity or concerns about creditworthiness.

Control Over Documentation:

With an LC, you have the authority to specify the exact documentation required for each shipment. This includes any paperwork necessary for customs clearance, ensuring a smooth and efficient import/export process.

Defined Shipment Deadlines:

An LC allows you to set clear deadlines for shipments to guarantee that your supply chain operates within a predictable and manageable timeframe. This is particularly beneficial in maintaining consistency in your operations and meeting your customers’ expectations.

Customisable Payment Terms:

One of the standout features of an LC is the ability to tailor payment terms and conditions to suit your specific business needs. This flexibility allows buyers like you to negotiate terms that align with your cash flow and operational requirements.

Establishing Credit Worthiness:

Utilising an LC can be a strategic move to establish or enhance your creditworthiness with suppliers. It demonstrates your commitment to fulfilling payment obligations, thereby building confidence and trust in your business relationships.

Payment Execution in a Letter-of-Credit Transaction

In an LC arrangement, the payment release hinges upon fulfilling specific conditions outlined by the buyer through the issuing bank or third-party financier. These conditions are meticulously detailed in the letter of credit and vary depending on the nature of the transaction. For instance, in international trade deals, the seller might be required to deliver goods to a designated port or shipping facility.

Upon completing the delivery, the seller obtains documents that verify the shipment. These documents, serving as proof of compliance with the letter of credit’s terms, are then presented to the issuing financial institution. The issuing bank’s role is to review these documents before releasing the payment.

Since the issuing bank mainly focuses on the fulfilment of terms rather than the quality of goods, buyers can incorporate inspection criteria into the deal. This ensures that an independent party verifies the shipment’s quality, adding an extra layer of security to the transaction.

Types of Letters of Credit

A letter of credit comes in various forms, each tailored to specific transactional needs. If you’re planning to use it, familiarise yourself with the common types:

Commercial Letter of Credit:

Often referred to as an import/export letter of credit, this is the standard form used in international trade. It involves a bank or any financier acting as a neutral intermediary, releasing funds once the agreed-upon conditions are met.

Standby Letter of Credit (SLOC):

Unlike the standard letter of credit, an SLOC is activated when a specified event fails to occur. It serves as a financial safety net, providing compensation if certain conditions are not fulfilled. Payment under an SLOC is made only when the beneficiary demonstrates that the agreed conditions have been breached.

Confirmed Letter of Credit:

A confirmed letter of credit involves an additional guarantee from a second bank, usually one trusted by the beneficiary or seller. This is particularly useful if the exporter has reservations about the reliability of the issuing financial institution. In such cases, if the issuing bank defaults even if the exporter has complied with the terms of the letter of credit, the confirming bank is obligated to make the payment.

Revolving Letter of Credit:

Designed for ongoing transactions, a revolving LC allows for multiple uses over a pre-agreed period, typically up to a year. This is convenient for importers and exporters engaged in regular business, eliminating the need for a new letter of credit for each transaction.

Domestic Letter of Credit:

This type of letter of credit is similar to the standard form but used within domestic borders. The seller must fulfil specific conditions, like delivering goods to a designated location, before payment is released.

Explore Trade Finance Solutions with darkhorsefinancial.com.au

If you’re considering a letter of credit for your business transactions, darkhorsefinancial.com.au is here to assist. Our expertise in trade finance, including letters of credit, equips us to provide tailored solutions that enhance your supply chain efficiency and secure your international trade dealings. Call us today to explore how we can facilitate your letter-of-credit needs and support your business’s growth and global reach.