What is a letter of credit?
A letter of credit is a letter from a bank guaranteeing that a buyer (for example, your customer) will pay a seller (you) on time and for the correct amount. If the buyer cannot pay, then the issuing bank will be required to cover the full or remaining amount of the purchase. So, you could summarise the letter of credit definition by saying that it’s a bit like having a co-signer on a loan.
Letters of credit are often used in international trade, where factors such as geographical distance, differing laws in each country, and difficulty in knowing each party personally multiply the hazards businesses can face.
A letter of credit from your customers can reassure you of their ability to meet their financial transactional obligations, because the invoice covered by a letter of credit will be paid. It is a way to and provide security in case something goes wrong with a transaction. It can be part of your credit management policy.
The letter of credit process involves at least three basic parties: a buyer, a seller and an issuing financial institution.
It’s best for your buyer to apply to the bank they do business and have an established relationship with, as opposed to applying at a new bank, especially if their company is new and doesn’t yet have an established credit history with excellent scores.
The letter of credit process requires them to provide full documentation of the agreement in question, as well as the bank's required application forms for internal processing.
At the conclusion of the transaction, if your customer doesn’t pay as promised, you must present relevant documents to the bank that issued the letter of credit. And, as we saw in the letter of credit definition, if the conditions are met, the bank must pay the due amount.
For example, if you required your customer to apply for a letter of credit as part of a transaction and you do not receive payment, you provide proof to the bank that the goods or services were received by your customer. The bank then pays you per the terms of the letter of credit.
Banks charge a fee for issuing a letter of credit and usually require a margin amount (cash or securities) as collateral. The amount required varies according to several factors, including the company’s credit score, transaction history, and how well-established the company is. Risky companies may be required to put up 100 percent of the purchase price to secure a letter of credit, while established ones with excellent credit history may be asked for as little as one percent of the total sales.
It is also important to note that a letter of credit usually covers only one transaction at a time, which means the letter of credit process must be continually renewed. Even when it’s your customer who is providing the letter of credit, you are still in the position of having to ensure everything is in order and then waiting for the bank to render a decision and issue the letter of credit. Time is money!
So the letter of credit cost in terms of the time and money your company spent will spend, is a factor to be considered when thinking about ways to secure your transactions.
Here are the advantages and disadvantages of a letter of credit:
Advantages of a letter of credit:
- Provides security for both seller and buyer.
- Issuing bank assumes the ultimate financial responsibility of the buyer.
- Guaranteed payment allows the seller to borrow against the full receivable value of the transaction from the lender.
Disadvantages of a letter of credit:
- Usually covers single transactions for a single buyer, meaning you need a different letter of credit for each transaction
- Expensive, tedious and time consuming in terms of absolute cost, working capital, and credit line usage.
- Additional need for security and collateral to satisfy bank’s coverage terms for the buyer.
- Lengthy and laborious claims process involving more paperwork for the seller.
Another solution for transactions with credit terms is . Also called accounts receivable insurance, it is basically ‘bad debt insurance’. If your customer fails to pay you or is late in paying you, the insurer indemnifies a proportion of your receivables. This guarantees an efficient protection of your cash flow in case of unforeseeable events and is the most reliable way to deal with insolvency risk.
- Trade credit insurance is a continued partnership, not just one bank-assisted transaction. It covers multiple transactions and multiple customers, whereas a letter of credit covers single transactions in a set time period.
- Trade credit insurance offers a similar guarantee of payment as a letter of credit but is generally cheaper than what a letter of credit costs. Trade credit insurance can often pay for itself: you can incorporate the cost of credit insurance into the cost of the goods. Increasing a product cost by just 0.10% can be enough to cover your costs for trade credit insurance, while the purchase cost remains neutral for the customer.
- Trade credit insurance removes burdens from customers and simplify transactions. You create a smoother transaction rather than presenting the customer with the additional cost and bother of obtaining a letter of credit.
- With trade credit insurance, knowing you will receive payment means you have the freedom to offer more favorable payment terms (open terms as opposed to the fixed terms in the meaning of a letter of credit).
- Trade credit insurance gives you increased access to capital because your lender is assured of the health of their accounts receivable, which isn’t the case of a letter of credit.
Additionally, trade credit insurance from Allianz Trade also offers predictive protection thanks to our global network of experienced risk analysts and finance professionals, so you can make better-informed business decisions. We provide credit protection and market insights with risk analysts evaluating current and potential customer behind the scenes, every day.