Letter of Credit Basics

Are you doing business overseas and your supplier has asked you for a letter of credit? Do you own a distributor, wholesaler or re-seller and have a large purchase order where you need a letter of credit to pay your suppliers?

As the number of national and international transactions grows, so does the number of suppliers that are asking to be paid with a letter of credit. A letter of credit is a financial instrument that serves two purposes. It ensures that your suppliers get paid (that’s why they ask for them). It also ensures that you get the goods you bargained for — otherwise the suppliers will not get paid. It protects both of you.

Letters of credit come in many flavors. The most common are:

Revocable Letter of Credit: A revocable letter of credit allows the issuer to modify it, amend it or even cancel it. Since a RLC can be modified, most suppliers don’t like it because it increases their risk.

Irrevocable Letter of Credit: An irrevocable letter of credit does not allow for amendments, modifications or cancellation unless there is agreement by the parties. Since it is a form of guaranteed payment, many suppliers prefer this type of payment option.

Standby Letter of Credit: A standby letter of credit is a payment guarantee — rather than a payment mechanism. Under the terms of the agreement, the supplier can draw on the letter of credit if the client does not pay.

Transferable Letter of Credit : A transferable letter of credit can be revocable or irrevocable. This type of LOC allows the recipient to transfer part or all of the benefits to another party.

Qualifying for a letter of credit is not always easy. It requires one of two things. First, the business owner can deposit the actual amount of cash needed for the transaction with the bank or financial institution that issues the letter. This, of course, is very expensive. A second option is to have a bank give you a line of credit, and issue the letter of credit using the line of credit as collateral. Although this is the most common method of financing a LOC, it is also the hardest because your business must qualify for bank financing.

There is another trade finance option though. It is called purchase order financing. Purchase order financing is ideal for companies that have exhausted their bank resources. The purchase order funding company provides you with the necessary letters of credit to pay your suppliers using your purchase order as collateral. The transaction is settled once your client pays. Purchase order funding is the ideal tool to grow your business to the next level.