What is a letter of credit?

Invoice Factoring Group

A letter of credit is a financial instrument that is designed to protect all parties in a purchase transaction. They are very common when importing goods, where the buyer and the seller are in different countries. If the letter of credit is written correctly it will ensure that the buyer gets the products they are purchasing and that the supplier gets paid for their product. Let's explain with an simple example.

Let's assume that you just got a large order for widgets from a large customer. Now, your company does not manufacture the widgets, but rather, it imports them from China and resells them. Although you have been working with your Chinese supplier for a little while and they know you, they still insist on being paid up front for the goods. On the other hand, you only want to pay the supplier once you have received and inspected the widgets to ensure they meet your criteria. Obviously, there is an issue of trust.

This is a common scenario in foreign transactions that can be addressed with a letter of credit. You can get a letter of credit from your bank and they come in many types - revocable, irrevocable, transferable and standby. The bank will ask you to post collateral to cover the amount of the L/C. Collateral can be provided in cash, or can be debited from an existing line of credit if you have one. Once the bank has the collateral, they will write the letter of credit so that your supplier is guaranteed a payment (by the bank) as long as they meet:

  • Your product design specifications
  • Quality requirements
  • Quantity
  • Packaging criteria
  • Delivery date and place
  • Inspection requirements

It's common for letters of credit to contain an inspection clause, where you hire a third party inspection company that looks at a sampling of the goods and ensures they meet your specifications. Payment is often made contingent to a successful inspection.

Although using a letter of credit adds complexity to the transaction, you can see how it reduces the risk for all parties. Furthermore, many foreign suppliers can take a letter of credit and actually get financing against it. This is common in Asian countries that have factories that are growing quickly.

The biggest problem that buyers have with letters of credit is that banks require the cash collateral up front. If your company just got a large order - one that exceeds your capitalization - you will need to come up with the funds, or risk losing the order. One alternative that has been gaining popularity as a way to solve this problem is to use a supplier financing technique known as purchase order funding.

As it name implies, the solution provides financing based on existing purchase orders. A finance company uses your order as collateral and opens a letter of credit on your behalf. This enables you to make the purchase from your supplier. The transaction concludes once your end customer receives the product and pays for it. Here is an article that has more details on purchase order financing and how it works. You can also read these articles to learn more about the product advantages and the qualification criteria.

The main advantage of using po financing is that you can finance orders based on the strength of the order itself. The finance company will look at the credit quality of your purchase order, the track record of your supplier and your experience executing similar orders. If they meet the funding criteria, the company will provide the funding and enable you to fulfil the order. This solution can be ideal for small importers who have booked a large purchase order and need funding to pay their foreign suppliers.

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