What is a Letter of Credit?

Letters of credit have been around almost as long as commercial trade itself. It is a guarantee from the buyer’s bank that states the payment of a buyer’s obligation will be received on time and in the correct amount. It takes many forms; a standby letter of credit is used for multiple transactions while a commercial letter of credit is used for just one.

Typically, a business will require a letter of credit from a buyer when they're unsure of the risk; specifically, if the buyer is perceived to have a higher risk of non-payment because they are new to the business, and/or if the buyer is foreign.

A commercial letter of credit cost is up to 3% of the total transaction amount, with other fees included. 

What are the drawbacks of letters of credit?

In today’s digital world, letters of credit can be a cumbersome, expensive, and time-consuming tool for facilitating a transaction. More importantly, letters of credit place a burden on buyers at a time when they want a transaction to go as smoothly and as quickly as possible.

Consider the following issues buyers often face with letters of credit:

  • It is up to the buyer, not the seller, to obtain and pay for any of it.
  • For commercial letters of credit, buyers must obtain a letter from their banks for every shipment.
  • It can tie up the buyer’s lines of credit with its bank, reducing their financial flexibility.
  • Even the smallest errors or problems with a letter of credit can cause a bank involved to refuse to issue payment once the shipment arrives.
  • The claims process can be lengthy and laborious and can be derailed by minor discrepancies in paperwork.

Because of these drawbacks, buyers may resist using letters of credit, especially if they are used to dealing with open account terms that allow payment after they have received a shipment.

Fortunately, there are alternatives—such as  trade credit insurance—that offer a more convenient and inexpensive option to streamline a transaction. 

table of letters of credit vs. trade credit insurance

Trade credit insurance can remove burdens from buyers and simplify transactions. Businesses that choose  accounts receivable insurance as a source of finance also benefit from safe sales expansion—domestically and abroad—to new and existing buyers. 

Transactions are quick and simple. You won’t have to rely on the buyer handling the burden of obtaining a letter of credit from their bank. Rather, you will know they are covered for the sale before the transaction even takes place. 

And when the unexpected bad debt loss does occur, the business can be confident they’ll be paid.

Using trade credit insurance, you can:

  • Create the means for easy payment that does not impact buyers’ access to credit.
  • Offer open terms and more aggressive credit limits to your customers.
  • Ensure that payment is based solely on compliance with the contract of sale.
  • Pursue safe sales expansion and gain access to more working capital to recapture the credit insurance cost.
  • Gain access to more working capital by giving their lender additional comfort in one of their largest assets: their  accounts receivable.

Additionally, trade credit insurance is considerably cheaper than letters of credit, with the cost being absorbed into a smoother transaction rather than presented to the buyer at an additional cost. Credit insurance is an everyday partnership, rather than a one-time transaction with a bank.

Allianz Trade provides credit protection and market insights with risk management analysts evaluating current and potential buyers behind the scenes, every day. Our priority is predictive protection.

Credit Insurance vs. Letters of Credit

Trade credit insurance offers a similar guarantee of payment as a letter of credit, but without the added costs and burdens. This solution is unlike letters of credit because it’s not just one transaction through a bank, it’s a continued partnership. Credit insurance allows businesses to protect themselves from non-payment, as well as drive growth and effectively manage risk. 

The cost of trade credit insurance is generally cheaper and can often pay for itself with the additional sales that are generated from offering more favorable payment terms. You can incorporate the cost of credit insurance into the cost of their goods. 

Simply increasing a product cost by 0.10% can be enough to ensure protection while the cost remains neutral for the buyers. The increased sales volume from open terms as opposed to letters of credit typically offsets the small increase in the margin.

Other Alternatives to Letters of Credit

Aside from trade credit insurance, there are other alternatives to a letter of credit. Those include:

  • Purchase order financing: Purchase order financing provides you cash up front to complete a purchase order. Under this agreement, a financing company pays your supplier for goods you need to fulfill a purchase order. The finance company collects payment from your customer who initiated the purchase order. The finance company then pays you, minus their fee. When using purchase order financing, you risk alerting your client to your cash flow issue.
  • Invoice factoring: Factoring insurance for receivables is an agreement with a third-party company to purchase accounts receivables at a reduced amount of the face value of the invoices. The factor provides a cash advance ranging from 70% to 90% of the invoice’s value. When the invoice is collected, the factor returns the balance of the invoice minus their fee. Invoice factoring may not protect against non-payment, depending upon contract details.
  • Standby letter of credit: While a commercial letter of credit is used for just one transaction, standby letter of credit insurance is used for multiple transactions. It can be tedious and time consuming to create, and they tie up working capital.
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What is credit management?  Credit management is defined as your company’s action plan to guard against  late payments or defaults by your customers. An effective credit management plan uses a continuous, proactive process of identifying  credit risks, evaluating their potential for loss and strategically guarding against the inherent risks of extending credit. Having a credit management plan helps protect your business’s cash flow, optimizes performance and reduces the possibility that a default will adversely impact your business. No two businesses are alike. That’s why your business needs a credit management plan tailored to its needs, industry and customers. Here is the  comparison for credit management strategy options: Which is right for your business?