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The use of letters of credit has become almost commonplace as more companies do business nationally and internationally. A letter of credit provides suppliers with the assurance of a guaranteed payment for their products, provided they meet their clients' quality and delivery terms. It also frees clients from the risk of having to make upfront payments to their suppliers and ensures that the suppliers only get paid if they deliver what they promised.
However, letters of credit have a catch. They are usually offered by banks and are secured against either a loan or a line of credit. In other words, to be able to obtain a letter of credit, you and your company must qualify for traditional bank underwriting criteria.
But what happens if you can't qualify because your company is small or new? Or, what happens if you get a purchase order that exceeds your ability to finance a letter of credit? Do you turn it away to the competition?
Fortunately, there is an alternative. It is called purchase order financing. Purchase order funding provides you with the necessary financing to fulfill large purchase orders, provided they are made by credit worthy customers.
As opposed to a letter of credit, the collateral for this type of financing is the actual purchase order. Because of this, purchase order financing is easy to qualify for, since it does not go through traditional bank underwriting requirements. However, you can only use this type of financing once you have an actual purchase order from a customer.
The purchase order financing transaction itself is actually fairly simple and works as follows:
· The financing company or their bank issues a letter of credit in favor of your supplier
· The supplier manufactures the product and ships drop ships it to the buyer
· The buyer receives the product and accepts it. Your supplier gets paid by cashing the letter of credit
· Your customer (the buyer) pays for the order, usually 30 days or so after receipt. The financing company is paid back for its services and all remaining funds are yours.
One of the interesting features of purchase order financing is that in most cases, you have few out of pocket expenses. It's truly a transaction where you can use other people's money to grow your business.
Lastly, purchase order financing is frequently integrated with invoice factoring. This is a widely used trick that can help reduce the cost of financing the transaction, thereby increasing your profits.
Letters of Credit are incredibly useful and sometimes necessary tools in the course of international trade. They essentially serve to notify a seller of goods that a buyer has a line of credit with a credible financial institution. This allows the seller to feel more assured that in the event the buyer is unable to cover the costs of the goods, the seller will still get paid by the bank.
Enforceable Letters of Credit authorize a company to “draw” on the bank up to an aggregate amount upon demand according to certain terms and condition. The Letter of Credit must specify the total amount that may be drawn by the company from time to time, usually upon written demand. The bank promises to honor the demand, again up to a certain amount.
The letter of credit should also include the term of the line of credit, whether it is indefinite or whether it will only continue up to a certain expiration date. A provision discussing automatic extension of the agreement may also be included. Usually the bank will have the option to notify the company in writing that they are electing not to extend or renew the line of credit. In this case, the company will be responsible for paying the amount outstanding on or before the expiration date of the agreement.
There is typically a fee for opening a line of credit with a bank. The applicant pays the LC fee to the bank, and may in turn charge this on to the beneficiary. From the bank's point of view, the LC they have issued can be called upon at any time (subject to the relevant terms and conditions), and bank then looks to reclaim this from the applicant.
It is critical to define the parties to a Letter of Credit agreement – most importantly the beneficary and the issuing bank. The beneficiary is the party entitled to payment as long as he can provide the documentary evidence required by the letter of credit. The letter of credit is a distinct and separate transaction from the contract on which it is based. All parties deal in documents and not in goods. The issuing bank is not liable for performance of the underlying contract between the customer and beneficiary. The issuing bank's obligation to the buyer, is to examine all documents to insure that they meet all the terms and conditions of the credit. Upon requesting demand for payment the beneficiary warrants that all conditions of the agreement have been complied with.
The issuing bank's liability to pay and to be reimbursed from its customer becomes absolute upon the completion of the terms and conditions of the letter of credit. Under the provisions of the Uniform Customs and Practice for Documentary Credits, the bank is given a reasonable amount of time after receipt of the documents to honor the draft. The issuing banks' role is to provide a guarantee to the seller that if compliant documents are presented, the bank will pay the seller the amount due and to examine the documents, and only pay if these documents comply with the terms and conditions set out in the letter of credit.