Letter of Credit: Definition, Process, & Different Types Explained

A letter of credit is a document that a bank issues to guarantee payment to a seller. The bank promises to pay the seller as long as the seller meets all the terms agreed upon in the contract. This guarantee gives both buyers and sellers extra security.

Most letters of credit are used in large purchases, especially imports and exports. If you worry about trust issues with your customers or your vendors, a letter of credit can reduce that concern. Banks act as neutral parties in these deals and release payments only when the parties meet the conditions.

The key point is that a letter of credit is a bank’s commitment. It is not simply a suggestion—it is a legal promise to pay, provided every requirement is fulfilled.

This article provides an overview of letters of credit, the key participants, and how the process works. We also examine the financial benefits provided by letters of credit and how businesses can further strengthen their cash flow and accounts receivable process by complementing letters of credit with trade credit insurance.

A letter of credit sets out the steps banks and businesses follow in international trade. Understanding its main terms, required documents, and handling changes helps keep transactions smooth and safe.

The basic parts of a letter of credit lay out the rules for payment. These often include the amount, expiration date, and the latest shipment date. The letter will also name the issuing bank (the buyer’s bank), the beneficiary (the seller), and the applicant (the buyer).

A letter of credit often spells out payment terms, such as payment at sight or after a set period (for example, 30 days after shipment). It acts as a guarantee from the bank, which means sellers are more likely to get paid even if the buyer cannot pay. In cases of non-payment by the buyer, the issuing bank is responsible.

You may see a letter of credit compared to a surety bond. Both provide financial security for parties in a deal, but a letter of credit puts more focus on payment for goods or services in trade.

The key details usually appear in a table, such as this example:

A letter of credit also lists the specific documents that sellers must present to get paid. These are often the commercial invoice, bill of lading, packing list, and sometimes insurance documents.

Sellers must submit these documents within a set time, called the document presentation period. If the documents do not match the letter of credit exactly, the bank can refuse to pay. Attention to detail is critical.

For customs, the letter of credit may require extra paperwork, like inspection certificates. The goal is to prove you shipped the correct goods at the right time, meeting all terms.

When you trade with companies in other countries, you often face unfamiliar rules and different business practices. Letters of credit help you overcome these barriers by providing a clear agreement on payment terms and shipping conditions.

With a letter of credit, your buyer’s bank promises to pay you once you meet all the agreed terms. This makes it easier to trust international buyers, even if you have not worked with them before. As a result, you can grow into new markets with less worry about not getting paid.

You also benefit by having a reliable payment process, which lets you plan shipments, manage cash flow, and keep your accounts receivable under control. Many businesses use letters of credit to secure timely payments and avoid long delays.

Doing business overseas comes with financial risks. You might worry about the creditworthiness of your trading partners or political and economic changes in their countries. Letters of credit help you reduce these risks by transferring much of the payment risk to the bank.

If your buyer cannot pay because of local problems, the bank that issued the letter of credit must pay you if you meet all the documented terms. The bank’s guarantee makes your contracts safer than using open-account or advance payment methods.

Letters of credit provide favorable payment terms for both exporters and importers. As an exporter, you know you will be paid once you ship goods and provide the required documents. This allows you to use your accounts receivable as collateral for short-term financing, making it easier to manage your working capital.

Importers also benefit. Payment goes through only when the exporter shows proof that goods are shipped according to the agreement. This helps importers get access to finance since their bank understands that there is extra assurance that the goods will be delivered as agreed.

Banks sometimes offer special financing linked to a letter of credit, such as packing credit before shipping or post-shipment loans after the goods are sent. By using these financial tools, you can take advantage of international business opportunities while protecting your interests.

Using letters of credit provides several benefits, especially when considering how banks track the use of these instruments to assess a company’s financial stability:

• Helps sellers protect cash flow and manage accounts receivable.
• Improves relationships with lenders.
• Enables added flexibility in securing payments from customers.
• Allows sellers to leverage guarantees to receive early payments from their bank.
• Shows banks and other partners that sellers and buyers have sound financial practices.

As a buyer, if you consistently meet your obligations, you can strengthen your business credit profile. Good credit can help you access lower interest rates and apply for higher credit limits. Suppliers and partners may also view you as a safer business partner. This can open doors to better payment terms and larger order volumes.

Letters of credit are particularly beneficial when selling goods and services internationally, where you face the risk that buyers might delay or fail to pay. With a letter of credit, a bank guarantees payment as long as you provide the required documents.

In some cases, banks may offer loans or advances based on the letter of credit. This helps you avoid cash shortages and keep your business running smoothly. Better control over your receivables also allows you to pay suppliers on time. This can support steady operations and help you avoid late fees.