A letter of credit, also known as a credit letter is granted from the bank as a guarantee that the seller will receive the payment on promised time from the buyer. If the buyer fails to pay, the bank will be responsible to make the payment on behalf of the buyer. It may be processed as financial assistance that is a loan.
There are various provisions in international dealings considering factors such as distinct laws in every country, distance, and inefficiency to know the parties personally. Due to these factors, the use of letters of credit has gained significance in the process of international trade.
How a Letter of Credit Works?
Usually, the letter of credit is issued to assure the seller that they will be paid on time and with the right amount as a guarantee by the bank. After sending the letter of credit, the bank charges a fee, around the percentage of the credit letter. It also requires collateral from the buyer.
Types of Letters of Credit
There are various types of letters of credit such as revolving letters of credit, commercial letters of credit, and confirmed letters of credit. Here is a brief about them.
Commercial Letter of Credit
Under this letter of credit, the issuing bank directly makes payment to the beneficiary. It is a direct payment method. Whereas, the standby letter of credit acts as a secondary payment method in which the bank makes payment only when the buyer is unable to do so.
Traveller’s Letter of Credit
Those travelling abroad will be guaranteed that the bank or the issuing financial institution will consider drafts made at specific foreign banks.
Revolving Letter of Credit
This credit letter enables the buyer to make multiple draws within a specified limit and time period. It is beneficial to use for the shipment of merchandise processed frequently. Thus, there is no need to repetitively edit or rewrite the credit letters.
Confirmed Letter of Credit
This letter includes a bank other than the issuing bank that guarantees the credit letter. This second bank provides confirmation and is generally the seller’s bank. The confirming bank makes sure that the payment promised under the credit letter is made even if the seller and issuing bank fail to do so. The issuing bank under international transactions asks for such arrangements.
Benefits of Letter of Credit
If your small export business is regularly involved in international transactions, then a letter of credit will have numerous benefits for you. Here are a few advantages of using a letter of credit for your small export business.
Reduces the risk of having non-paying buyers
The credit letter ensures that the payment is made when all the agreed terms and conditions are fulfilled. In case the foreign buyer cancels or makes changes to the order, the letter of credit makes sure that the seller gets paid by the buyer’s bank for the goods shipped. Thus, it reduced the production risk.
A letter of credit helps the seller in a situation where the buyer fails to make the payment or goes bankrupt.
You can have a Personalised Letter of Credit
Letters of credit are conveniently customisable. It enables the buyer and seller to land on mutual agreements on the terms and conditions related to the promised payment transactions. If the terms and conditions have to be different for another transaction, they can again be customised through a different agreement by the buyer’s bank.
A credit letter grants foreign buyers the opportunity to decide when the date of shipment and delivery.
Buyers can Prove their Solvency
If an SME wants to purchase something, whether equipment, inventory or anything else, a credit letter works as a guarantee to the supplier that their payment provisions will be fulfilled. This is helpful whenever your business requires equipment or supplies on an urgent basis and you, at that time are unable to afford transaction delays.
It is not a Complex or Time-Taking Process
If you want to make a huge purchase quickly, the process of applying and getting a letter of credit is not a time-taking one. You can easily file an application online and usually the application is processed on the same day of application. All you have to take care of is that all your documents and paperwork are on point.
Enables the Sellers to Conveniently Manage their Cash Flow
Along with guaranteed payment, a credit letter makes sure that the payment is made on the mutually agreed time. This is an important thing because there is a significant time gap between the shipment of goods and payments, especially when it is a deferred payment.
A letter of credit guarantees the seller that they will receive their payment on time which enables them to accordingly maintain and manage their cash flow. The sellers can also have financing between the delivery of goods and receipt of payment which will provide a cash boost in a short duration of time.
Conclusion
Having an EPCG License is also a beneficial factor for small export businesses. The DGFT consultants who have expertise and years of experience in the field will help you get through every process smoothly and conveniently, granting you immense success.
Considering what we have discussed above, letters of credit play a prominent role in trade transactions. There are different types of credit letters for various purposes which can be used as per the needs and requirements.
If you want to have a letter of credit for your small export businesses, the bank you are currently associated with is the best to start your search from. However, you may further need to expand and incorporate larger banks if you have accounts at a comparatively smaller bank or financial institution.
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