Cash inflow is the fuel that is needed to sustain any business irrespective of its scale. The monetary infusion, ascertaining smooth sailing of the business operations, can be obtained from various sources obtained in the form of either an investment, a payment, or interest. The importance of positive cashflow is further highlighted when you are planning on expanding your business beyond the domestic boundaries and exploring foreign markets through international trade. But due to certain factors like the inability to meet with the buyer face to face, payment uncertainty, and different trade laws of each country, the risks associated with the international trade escalate. Letter of Credit (LC), unbeknownst to many small business owners, ensures a prompt and reliable remittance from buyers around the world. An immense application and utilization of letter of credit have been observed in foreign transactions and shipment of goods in the export/import industry. Let us understand the letter of credit and how you may benefit from it to further your revenue stream.
What does a Letter of Credit mean?
In simple language, a letter of credit would be described as a guarantee and assurance provided by a third party that bears no partiality whatsoever neither to the buyer nor the seller. It is a written document presented by the importer’s or buyer’s bank on his/her behalf. In case of a situation or event rendering the applicant or buyer incapable of holding true to their transaction commitments, the bank will ensure that the seller receives their payment which the buyer is obligated to. This backing from a financial institution builds on the transactional security of a global business trade while establishing a safety net for the seller in case of non-fulfilment of the remuneration by the buyer.
Mechanics of a Letter of Credit
The crux behind the issuance of a letter of credit is to help the parties involved in a trade to mitigate risk associated with overseas business transactions. It safeguards the vested interests of the parties involved in the business relationship wherein the bank acting as the intermediary secures them in case of non-fulfilment of the commitment which they agreed to in the terms and conditions.
The functioning behind this is fairly straightforward. Suppose, your business or company obtains a considerably sized order from an overseas client. There will be plenty of factors that would occupy your earnest focus and consideration, ranging from getting the order shipped to ensuring its arrival or delivery on time. In a preoccupied situation like this, where your core focus should be on the proper functioning and expansion of your business, one should not be pulled back by a circumstance like not getting paid timely. This fear should not be acting as baggage or hurdle to your business.
This is where a letter of credit comes to your rescue. A bank situated in the buyer’s country will issue a letter of credit dictating the buyer’s obligation to the seller and specifying the amount as well as the point in the transaction when that amount is due to the seller. Doing the necessary legwork to facilitate the payment process and to ensure that the buyer has the means to meet the money demands of what they have bought will fall under the purview of the bank which has issued the letter of credit. It certifies the capability of the buyer to afford what they have purchased.
While being involved in an international trade transaction, a shortfall of capital can be experienced by the exporter during various stages of the working cycle. This is where export credit serves a paramount role in financing business expansion and operation. The methods of finance that can be availed by exporters post-shipment are LC discounting, invoice factoring or export factoring, and export bill discounting. Export credit expedites the payment process where the financial intermediary of the exporter facilitates the quick payment upon shipment of goods by the seller or exporter.
As an exporter, an unavoidable facet of the transaction is that you will not be paid immediately against your export invoice. For resolving the working capital needs of the exporter, export bill discounting proves to be beneficial as a credit facility, which also allows the exporter to accept new orders that lack of resources would have restricted.
Exporters can benefit from a financing process called LC discounting if they want to fulfill the financial requirements of their businesses through discounting of bills backed by a received letter of credit. The advance payment enables a consistent cash flow and working capital for the exporter’s business during the production process and requires the submission of export and customs documents.
The process to get a Letter of Credit
Depending on your specific needs, the process can look different, but the basics remain the same.
Types of Letter of Credit
Different types of letter of credit utilize separate or varied ways of handling the transactions. Here are the types of letter of credit for a brief understanding and easy reference.
Revocable Letter of Credit
There is no prior or advance notice that is required to be given to the beneficiary by a bank before changing the terms of the letter or canceling the letter entirely. It bestows upon the bank an ability to alter the terms and conditions of the letter of credit.
Irrevocable Letter of Credit
Irrevocable LC cannot be modified without the consent or agreement of all the parties involved which includes the beneficiary, issuing bank, and the confirming bank. It is deemed as the safer option for the exporter owing to the fact that on submission of documents adhering to the terms and conditions of the agreement they are assured of payment of the amount mentioned in the LC.
Commercial Letter of Credit
The responsibility for the payment to the beneficiary falls under the purview of the bank.
It entails a guarantee of the funds as well as the disbursement by the bank to the beneficiary.
Standby Letter of Credit
The transaction handling process is the opposite of a commercial letter of credit. The role of the bank in making the payment to the seller or beneficiary is only limited to a situation when the buyer displays an inability to pay the beneficiary and fails to accomplish his end of the deal.
Traveller’s Letter of Credit
This allows you to take money out of approved banks even if you are travelling or planning to go abroad. It ensures that you have the access to the funds that you are owed and are guaranteed to you.
Revolving Letter of Credit
In the case of a long ongoing business relationship with a foreign buyer, the need to issue a new letter for each transaction is eliminated as a revolving letter of credit allows the applicant to make purchases again and again once they pay the letter amount. It reduces inconvenience if you have a series of transactions with the same buyer.
What does a back-to-back Letter of Credit mean?
A back-to-back letter of credit is a viable and favourable option in a situation where the seller might want to subcontract a part of the product manufacturing to another party referred to as the third party here but doesn't have the cash flow to support it.
The process will require the seller to apply with his bank for the second letter of credit of lesser value, followed by sending it to the third party's supplier bank. This guarantee bestowed on the third party will assure it to proceed with its part of the transaction without the risk of non-payment.
Letter of Credit - an example
The best way to understand a concept is through examples that will walk you through the process. Hence, to impart to you a thorough and comprehensive understanding of what the process involves, here is a letter of credit example. Let us assume that two companies are planning to form a business relationship with each other for international trade. Company X sells bags in Alabama while company Y is involved in the manufacturing of the bags with whom company A wants to strike a deal amounting to a worth of $ 150,000. At this point, the decision to take the deal forward by company Y may be clouded by uncertainty and apprehensions owing to the lack of credibility and opportunity to understand the company its business operations. Here a letter of credit will play a crucial role in moving the transaction forward by backing the creditworthiness of company X and guaranteeing payment to Company Y in case the applicant defaults.
Company X approaches its bank, Bank of Alabama, to get a letter of credit and assuring that it will hold true to its end of the deal by making the $150,000 payment as per the agreed time. For the letter of credit to be issued, the bank will require cash collateral along with issuance fees from company X. Following this, the Bank of Alabama will send the letter of credit to Company Y, which upon being assured and guaranteed agrees to the trade and subsequent shipment of the bags. Succeeding the shipment Company Y can ask for its payment from Bank of Alabama, which will turn to Company X for reimbursement, after presenting written proof via documents that include the bill of lading and commercial invoice.
Benefits of a Letter of Credit
A letter of credit safeguards the interest of both the parties involved in an overseas business transaction, whether it be the buyer or the seller. It provides the seller with payment assurance and a guarantee, thus cutting loose the uncertainty and risks associated with expanding your business in foreign territories with people with whom you cannot have face to face interaction. On the other hand, in the case of the applicant or buyer, the funds are secured and protected from reaching the seller until the goods hit a certain point in the delivery process as elaborated in the terms and conditions of the LC.
It defends the interests of the seller and buyer from being compromised through mutually agreed terms and conditions. It is a safer option for the seller in case the applicant goes bankrupt as the exporter will be insulated from the fluctuation that happens in the buyer’s business.
Risks associated with a Letter of Credit
There is no denying that the sense of security that a letter of credit provides to the parties involved is substantial, but it cannot secure the transaction from any foreseeable and unforeseeable factors other than the business financials. The cost of operating the formalities of LC procedure is high and adds extra weight to the existing expenses.
At no point in the process, it ensures the quality and authenticity of the goods that the applicant or buyer will receive. Also, due to the exerted terms and conditions, there is no scope of delay in shipment or delivery of the goods to the buyer caused by unexpected circumstances. Thus, ensure that you are comfortable and well aware of what the transaction entails along with the timely submission of necessary paperwork from both the parties as there is no leeway for non-fulfilment of the mandatory paperwork.
It also doesn’t shield the buyer from a situation where the transaction is obtained through fraudulent means or a situation where the transaction completion is prevented due to regulatory actions of the government.
One of the biggest drawbacks of LC is currency fluctuations or forex rates. As the purchase orders along with the opening of a letter of credit by the buyers are usually placed once in a year, there are chances for the exchange rate to differ at the time when the payment is carried out to the seller.
MyForexEye is committed to providing a resolution to your Forex and trade finance needs and filling the gap of the unmet demands in terms of credit and financial guidance to MSMEs and larger corporates. Through our team of experienced professionals and consultants well versed in the field of trade finance, we dispense streamlined processes for one’s convenience and at one’s disposal. The force at play, corroborating our efforts of providing solutions that are effectual to companies for realizing their maximum potential, are the latest technology and assistance from the veterans of the trade finance industry. It is our objective to aid our clients in making savings and eliminating the aspect of hidden commission fees payable to the bank. Our user-friendly digital platforms- web portal and mobile app, renders one capable of accessing instant quotes and calculating interest costs.
Speak to one of our specialists to acquire a detailed understanding of letter of credit or other trade financing facilities.
Disclaimer- The website is to provide information only.
10 Mar 2021 05:00 PM
It operates for five days a week and 24 hours a day wherein currency is traded electronically, the value of which is dictated by the fluctuating foreign currency exchange rates. The forex market's importance is not just confined to larger corporation
04 Mar 2021 03:08 PM
Contrary to popular beliefs, the forex market's importance is not just constricted to commercial banks and large corporations. The smallest of the operations involving an individual
11 Aug 2020 07:01 PM
Online currency trading platforms and a reduced barrier to entry, Forex or currency trading has witnessed a surge in individual investors' participation.
21 Jul 2020 06:13 PM
A country’s exchange rate and its imports and exports hold a complicated relationship as there is a constant feedback circuit between the way a country’s currency is valued and the international trade.
29 Jun 2020 05:35 PM
Dynamic hedging is a foreign exchange risk management strategy that allows businesses and individuals to readapt their hedging positions to evolving market conditions by providing flexible solutions to protect investments from exchange rate risks.
19 Jun 2020 05:01 PM
Management of Currency Exchange Risk is of paramount importance during turbulent times, like this pandemic. The currency fluctuations are very volatile and cannot be predicted as the circumstances are uncertain.