For business owners looking to increase inventory or purchase goods from an international supplier, one of the hindrances often lies in providing the supplier with proof that they will receive payment. Without that proof, it can be a challenge to secure the inventory the business needs to generate its own sales. A Letter of Credit (LC), usually issued by a financial institution, acts as an irrevocable guarantee of payment to the beneficiary. In other words, if the company ordering the inventory cannot meet their repayment obligations, the bank will pay.

The LC is also used as a source of payment for a transaction, as in the case of an exporter who is guaranteed payment with the redeeming of the LC. These are primarily used in international trade transactions between a supplier of one country and a customer in another. Generally, the supplier would be required to present proof of a shipment in the form of a commercial invoice or bill of lading, as well as insurance against loss or damage during transit, in order to receive payment.

Consider this example:

Calculators Plus, based in the U.S. imports products from a Korean manufacturer called Calculator Manufacturing, which banks at a Korea-based Bank. Calculators Plus banks with a America-based bank. In this example, Calculators Plus serves the role of applicant. Calculator Manufacturing is the beneficiary. The America-based bank is the issuing bank and the Korea-based bank is the advising bank.

Calculators Plus desires to purchase $50,000 worth of products from Calculator Manufacturing, which agrees to sell the merchandise and gives the company 60 days to pay it with the condition that they provide a 90 days LC for the full amount. The applicant would have to take the following steps to secure a LC:

Request a $50,000 LC from the America-based bank with Calculator Manufacturing as beneficiary.

The issuing bank goes through its full underwriting process. Although the bank is not advancing money, they are extending credit on the behalf of the applicant and are taking on a contingent liability. As long as the company qualifies from a credit standpoint, the LC is issued.

Issuing bank sends a copy of the LC to the advising bank, which notifies the beneficiary that payment is available and they may ship the merchandise ordered by the applicant with full assurance of payment.

Once the required documents have been presented and compliance with the terms and conditions of the LC has been met, the issuing bank transfers the $50,000 to the advising bank, which credits the account to the beneficiary for the full amount.

As mentioned before, the LC itself can also serve as the source of repayment of the transaction. Say for example that the Korea-based bank is interested in receiving payment as soon as the merchandise is shipped. The LC would then indicate that payment should be made as soon as Calculator Manufacturing can present proof of shipping.

The above example describes the simplest of LC transactions. Although there are other factors involved such as the role of correspondent banks and confirmations, the issues a business owner should most be aware of is expediency and the fees involved, which can cost between 1.5% to 8% of the value of the LC.

There are several types of letters of credit which a business should be aware:

Revocable Letter of Credit: The LC can be revoked by the issuing bank without the agreement of the beneficiary.

Irrevocable Letter of Credit: The LC cannot be cancelled or amended without all parties in agreement.

Revolving Letter of Credit: This type of LC is established when there are regular shipments of the same commodity between supplier and customer; eliminating the need to issue a LC for each individual transaction.

Stand-by Letter of Credit: A payment or performance guarantee used primarily in the United States. These LCs are used as backup should the buyer fail to pay as agreed. Thus, the Stand-by LC allows the customer to establish a rapport with a seller by showing that it can fulfill its payment commitments. Stand-by letters are generally less complicated and involve far less documentation requirements than irrevocable LCs.