What is letter of credit?
A letter of credit is an agreement between two parties’ i.e. buyer and seller. The letter is issued from the buyer’s bank guaranteeing that the payment will be made to the seller on time and for the specified amount.
If the buyer fails to make the payment then the letter of credit is used by the seller. The buyer’s bank will make the payment of the required amount (It can be the full amount or the remaining amount left by the buyer to pay)
Why is the letter of credit important?
In modern times, every business transaction carriers a risk and letter of credit is the safety net while taking the risk. Every seller fears the possibility of not receiving the payment of the specified amount or on the given due date. Letter of credit acts as a proof of guarantee that the seller will receive his payment on time without delay.
It is not only beneficial to sellers but also buyers in avoiding scams and taking unnecessary risks. It is designed to safeguard both parties from unnecessary risks and circumstances; the seller can only get his payment by presenting the relevant documents that the shipment has been made and the letter of credit is issued to him. Only after fulfilling every condition, the seller can avail his payment.
Its primary purpose was to safeguard the seller but now it has evolved to not only protect the buyer but also to maintain relationships between businesses and promote international business transactions.
Importance in international trade
Thanks to globalization, our world is getting smaller day by day but risks are also increasing. Risks are not only related to unknown buyers sitting miles and miles away but also political and natural circumstances in one country can cause a loss to the seller in another country.
Therefore, buyers and sellers need to protect themselves by means of LC. In international transactions, it is difficult to communicate because of different languages, work culture and financial laws. A letter of credit clarifies details across the board with the written down terms and conditions. It helps to avoid any future misunderstandings which can either terminate the transaction or void the letter.
HOW IS IT BENEFICIAL?
Advantages for the seller
- The seller will receive his payment from the buyer’s bank if the buyer fails to pay.
- Reducing the risk where the buyer cancels or changes his order which will also eliminate in an irrevocable letter of credit.
- The seller can avail his payment before the due date (.i.e. lc discounting) this is only applicable after the goods have been shipped.
- The buyer will not be able to refuse to pay the seller due to a complaint about the goods once the acceptance is given under LC (there are different letters and details for further buyer protection)
Advantages for the buyer
- Only after certain conditions put forth by the buyer is met by the seller and all the required documents are checked by the bank, the seller can receive his payment.
- The buyer can control the period for shipping of the goods
- The buyer can put forth his integrity and solvency to the seller
- The letter of credit will eliminate the need for pre-payment.
- One of the main advantages the buyer gets improved cash-flow as he gets credit by the way of letter of credit from the bank till the Usance period of the LC i.e. he has to pay after 90 days if the 90 day period is written in the LC.
1. Inspection certificate
The bank is not concerned with the inspection of goods but that doesn’t mean that the seller has the freedom to loot his customers. The buyer can insist on an inspection certificate as part of the deal, which means that an individual will review the goods in the shipment and ensure if the standard or the quality of shipment is as agreed upon by the seller and the buyer.
2. Discounting of LC
Let’s assume that a seller needs urgent money to pay some bills, but the letter of credit allows payment on the given due date. There is a way for him to get the money before the date i.e. by discounting his letter of credit.
Seller will go to his bank with the letter of credit and the bank will purchase his bill and certain other documents after the seller have met with certain conditions. The Bank gives him the amount but bank will deduct an amount termed as interest. The amount deducted is the service charge of giving the money early to the seller.
However, the seller can only discount his LC after the shipment has been shipped.
3. Usance Period
It is a permitted period for the buyer between the date of bill and the due date where payment has to be made. For e.g.:
- X purchased goods of Rs.5000/- from Y on 1st Jan 2020.
- They agree that X will pay Y in 90 days i.e. on 31st March 2020.
- Therefore, the period between 1st Jan and 31st March is called the usance period
It differs from country to country and product to product. For capital goods, the maximum period of LC can be issued is 3 years whereas for import/export goods the maximum period of LC can be issued is for 180 days. It’s also used as a financial tool where the buyer buys raw material converts into finished products and sells it within the usance period and pays the seller on the due date.