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Letter of Credit: What Is It and How Does It Work?

man in warehouse organising letter of credit

A letter of credit is a way for banks or other financial institutions to guarantee payment and the delivery of goods. This form of payment can seem confusing if you’re not familiar with how it works. Let’s take a closer look to understand letters of credit and how they can facilitate transactions between buyers and sellers, particularly in international trade.

Facilitate trade and reduce payment risk with a letter of credit

When a business sells to another business domestically, the transaction is fairly straightforward. The seller will check the credit history of the buyer and, if approved, invoice the buyer for the goods delivered. If the buyer fails to pay and doesn’t respond to collection efforts, the seller can take the buyer to court and get a judgment for the amount owed.

However, when the buyer and seller are in two different countries, the risks increase. From the seller’s side, there’s the risk of not getting paid after the products are delivered, called credit risk. Given the large distances, different legal systems, and the cost of legal action, it would not be feasible to take legal action if payment is not received. From the buyer’s side, there’s the risk of not receiving the products if prepayment is made for the shipment, or receiving substandard products. A letter of credit solves the issues for importers and exporters involved in international trade.

Letter of credit basics

A letter of credit (LC) is a common form of trade finance that ensures that the payment for goods and services will be fulfilled by the buyer. The rules surrounding letters of credit are defined by the International Chamber of Commerce through their Uniform Customs & Practice for Documentary Credits which is followed by producers and traders around the world. When an LC is used for a trade transaction, both sides of the transaction use an intermediary, a bank or other lender, to issue an LC and guarantee that payment will be made for the goods received.

The steps for using a letter of credit

Usually, there are seven steps that are followed in order to get paid using a letter of credit as a payment method: 

  1. The importing company (purchaser) arranges for a letter of credit to be opened by the issuing bank in favor of the exporter (seller). 
  2. The issuing bank sends the letter of credit to the nominated bank, which forwards it to the exporting company. 
  3. The exporter sends the goods and documents to a freight forwarding company. 
  4. The freight forwarder ships the goods and the documents are sent to the nominated bank, either by the exporter or forwarder. 
  5. The nominated bank checks the documents to confirm that they comply with the terms of the LC and receives payment from the issuing bank for the exporting company. 
  6. Funds are debited from the importer’s account at the issuing bank.
  7. The issuing bank releases the documents to the importing company to get the goods from the carrier and clear them at customs.

Types of letters of credit

There are many types of letter of credit that are used to fit the particular circumstances.  

Commercial letter of credit – the standard letter of credit that’s used in international trade transactions and sometimes called an import/export letter of credit. Acting as a neutral third party, the bank releases funds after the agreed conditions have been met. 

Standby letter of credit (SLOC) – this is different to the standard LC in that it goes into effect when something fails to happen. It provides compensation if something goes wrong, instead of facilitating the transaction. These are only payable when the beneficiary can prove that the conditions agreed upon have not been met. 

Confirmed and unconfirmed letters of credit – with a confirmed letter or credit, another bank (presumably one that the beneficiary trusts) provides a guarantee that the payment will be made. If an exporter does not trust the bank that issues the letter of credit for the buyer, they might require that a bank in their own country confirms the LC. In this case, if the issuing bank fails to pay (and the exporter meets all requirements in the letter of credit), the confirming bank will have to pay the seller. With an unconfirmed letter of credit, there is no guarantee from a local bank. 

Revolving letter of credit – this LC can be used for multiple payments. If the importer and exporter plan to do business over time, they might not want to get a new letter of credit for each transaction. The revolving LC can be used for transactions until it expires, usually up to one year. 

Domestic letter of credit – this is similar to the commercial LC but used for domestic transactions. In this case, the seller must meet certain requirements (such as the buyer receiving the goods at a specific location) before the funds are released.

Pros and cons of using an LC

There are a number of good reasons to use a letter of credit. These include:

  • Avoiding disputes involving domestic and international transactions
  • Getting a guarantee that the supplier will get paid
  • Having range of choices for the most suitable type of LC
  • Moving the risk from the purchaser to the bank.

At the same time, there can be disadvantages:

  • Additional cost in the form of fees and charges
  • Time consuming nature of ensuring the paperwork is correct – the seller has to ensure the terms and conditions are met in order to get paid
  • The bank issuing the letter of credit will want some form of security from the buyer before it commits to the LC.

Alternative finance options for wholesale and distribution businesses

Wholesale and distribution businesses involved with importing and exporting often experience cash flow shortages due to the lag between purchasing and receiving products and selling them. Unsecured business loans are one way for these businesses to gain the working capital they need. 

Moula makes it easier for these businesses to access finance. Using accounting and banking data, the finances of the business are analysed safely and securely online to determine loan approval. 

The decision on loan approval is quick, so small businesses can get funds fast. With Moula, your clients will get an answer within 24 hours. Once approved, the funds are disbursed immediately. Loan terms are from six months to two years, so it gives the business time to overcome cash flow challenges. 

Find out more about business loans from Moula.

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All the thoughts, ideas and musings from the Moula team! Covering everything from work/life balance to general finance tips plus everything in between!

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