Everything You Need to Know About a Letter of Credit, How it Works, and More

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Ensuring payment security in export is vital for businesses to function. There are several ways to ensure that the seller receives their due payment on time. A letter of credit is one of them. In fact, it is one of the most secure methods used in international business transactions. Let us discuss about this payment method in detail.

What is a Letter of Credit?

A letter of credit is basically a legal document that businesses dealing with export processes use to make sure that they can get paid from the buyer on time. What it does is that it transfers the responsibility of collecting the payment from your business to the buyer’s bank for any shipped goods or services exchanged. The letter makes sure that even if your foreign buyer does not pay on time, the bank does so. You can use a letter of credit for export as leverage for your business, if the buyer fails to pay you on time.

There are many factors out of control of the seller’s hand in international trade. This can be a lack of personal contact, and even varying laws in different countries where your business might operate. This is why a letter of credit is useful because it works as a reliable payment mechanism.

The International Chamber of Commerce Uniform Customs and Practise for Documentary Credits looks after LCs issued in international trade.

There are three parties involved in a letter of credit:

1) The applicant (buyer)

2) The buyer’s bank that issues the LC

3) The beneficiary (your business)

Types of LCs

There are several types of LCs used in trade. Here are some of the common ones:

1) Sight Credit:

Under this kind of LC, the beneficiary can collect the funds immediately upon presenting valid documents. That is, your business can receive the payment immediately when you present the documents.

2) Time or Acceptance Credit:

The bills drawn at the time of sale are sometimes payable after a certain period of time allowed by customs. This period of time is called ‘usance’, and these bills are called ‘usance bills.’ Under the time/acceptance credit, the exporter can present usance bills on their due dates and receive payment.

Let us take for example, that a buyer buys some goods and/or services from your business. The bill reaches the buyer when the shipment reaches them. Let us assume that the buyer has an usance period of 30 days, up to which he can pay the bill. If the buyer does not pay the bill before the due date is up, your business will get the payment when the letter of credit is shown to the bank.

3) Revocable and Irrevocable Credit:

Under a revocable credit, the issuing bank can change the terms or even cancel the letter of credit. The bank can cancel the LC even without prior notice. In an irrevocable credit, the issuing bank cannot make changes in any terms.

How Does a Letter of Credit Work?

Issuing an LC is a complex process, that involves many parties, some international too. Here is how it basically works. Here are the five steps that you have to take to get a letter of credit:

1) The exporter and the buyer then sign a contract that details the goods and services exchanged for a set price. Next, the buyer has to apply for a letter of credit issued by their bank.

2) The bank checks the buyer’s credit risk, and if found okay, it issues the LC.

3) Your business exports the goods and then you submit the documents to your bank as proof of the trade.

4) Your bank then sends these documents to the buyer’s bank. Once received, the bank removes the amount from the buyer’s account and returns it to your bank.

5) And finally, your bank deposits the amount into your account.

Are There Any Alternatives to Letter of Credit?

A letter of credit is useful in business. But it can also be expensive sometimes, making it a less ideal option. Let’s look at some alternatives that are used in place of LCs.

In case an LC is not possible, you can use other arrangements like upfront payment or open account terms. Open account terms also offer flexibility in payments when dealing with competition overseas. Many businesses offer open account terms to trustworthy clients. This also decreases constraints in the deal and allows more trust between you and your buyer.

The Export Import Bank in India or India Exim Bank also offers many credit facilities. This enables exporters to expand their business to new areas. All of this without worrying about the complex international transactions. The Exim Bank insures against failure of payment only for Indian goods and services.

Conclusion

A letter of credit is a useful tool to ensure payment security in the export business. There are several kinds of LCs. These include Sight Credit, Time or Acceptance Credit, Irrevocable Credit, and Revocable Credit. There are also many alternatives to an LC. These include upfront payment, open account arrangements, or using the facilities of the Exim Bank.

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