In order to run a business smoothly, you need to ensure that your customers pay on time or deliver inventory even if they are overseas. To some companies, payment is automatic, but for others, it may not happen until they receive the ordered goods. To prevent customers from making large purchases without payment, you could take their word for it and hope nothing goes wrong, or instead, use a letter of credit to mitigate the risk.
Letters of credit assure business owners that they will be paid on time by their customers and vendors. There are multiple types of letters of credit, each with unique properties to match different businesses and situations. Understanding what each type of letter of credit is used for is essential for domestic and international businesses.
What is a Letter of Credit?
As mentioned above, letters of credit ensure customers and vendors pay for their goods on time while also ensuring they receive their purchases. They are official documents issued by a bank or other financial institutions that guarantee a specific payment will be paid for a transaction of goods.
If the purchaser, or the customer, does not pay for the goods on time or pay the exact amount owed, the bank that issues the credit letter will cover the remainder of the balance up to and including the full amount of the transaction.
A credit letter is beneficial for both parties, as it guarantees the customer will receive the goods and the business owner will receive payment. They are most commonly used in international trade between new businesses to help facilitate imports and exports.
Before a bank issues a letter of credit, many requirements must be met by both parties, as with any type of loan. These requirements vary by the type of letter of credit being used for a transaction. To meet and cover a variety of scenarios, there are several different types of letters of credit available to businesses.
Types of Letters of Credit
Each business has unique needs when it comes to buying and selling goods. In order to cover all bases and scenarios that may arise, there are different types of letters of credit to choose from. Some are more common than others, while others are used for more unusual situations. Understanding the different types of letters of credit will help you to find the right one for your business needs.
Commercial Letter of Credit
Commercial letters of credit are one of the most common types of letters of credit as it is the standard letter of credit. They are used in transactions that require some sort of payment for a good or service and are often seen in international trade.
Commercial letters of credit represent a promise to pay the holder if they fulfill their obligation. The bank that issues the letter of credit guarantees payment if anything falls through on the transaction. Foreign and domestic companies rely on commercial letters of credit to conduct business with unknown companies. Without a commercial letter of credit, exporters tend to ask for large deposits or other forms of payment to guarantee they aren’t going to lose money. Having a letter of credit avoids these costly alternatives.
Standby Letter of Credit
Unlike a commercial letter of credit, a standby letter of credit is a secondary payment method where the bank guaranteed the payment when the seller fulfilled the terms of the letter of credit. A standby letter will have specific clauses that the buyer must meet so that he can use the letter of credit.
For example, a clause in a standby letter of credit could be a demand, such as a purchase of dresses being sold needing to be 90% polyester and 10% rayon as well as being individually wrapped. They may also include items such as a lease or a long-term contract. In a commercial letter of credit, those clauses could not be included and only offer a general guarantee of payment.
Revolving Letter of Credit
Traditionally, a letter of credit is used once per transaction. A revolving letter of credit, however, can be used for multiple payments and transactions. Revolving letters of credit are used between two businesses that expect to do multiple transactions together, allowing them to avoid several letters of credit.
As with general letters of credit, there are multiple types of revolving letters of credit, depending on the needs of the companies involved.
Time-Based Revolving Letter of Credit – A specific payment amount can be drawn over a set amount of time. For example, if the letter of credit is good for $100,000 for ten months, payments of $10,000 can be made each month until the final amount has been reached.
Cumulative Revolving Letter of Credit – With a cumulative revolving letter of credit, if there aren’t any goods shipped or services conducted in one month, the payment can be combined to the next month’s payment.
Non-Cumulative Revolving Letter of Credit – Opposite to cumulative is a non-cumulative revolving letter of credit. It means that only a set amount of goods say the $10,000 from the previous example, can be shipped in a month. No extra goods can be shipped during that time and must wait until the next month.
Value-Based Revolving Letter of Credit – Payment to the buyer is only released when they receive goods or services worth a certain amount. If the exporter only has a partial amount, such as $5,000 out of $10,000 worth of goods, they cannot ship it out based on the value-based revolving letter of credit limits.
Deferred Payment Letter of Credit
A deferred letter of credit, also called a usance letter of credit, allows the bank to pay the beneficiary on a selected date after the transaction has been completed and the proper documents have been submitted.
These letters of credit are used when the buyer and seller are in two different countries and need assurance that goods will arrive when they should and payment is met. The payment from a deferred payment letter of credit can be delayed from 30 to 180 days, depending on the negotiation.
Confirmed Letter of Credit
Although a letter of credit is supposed to guarantee payment from a bank if the payment does not come through, a confirmed letter of credit ensures it with a second bank. The seller acquires a guarantee of payment from a confirming bank, or second bank, which avoids the risk of the first bank not paying.
Having a confirmed letter of credit ensures that the seller receives payment even if the buyer and the issuing bank default. You might also hear the term unconfirmed letter of credit in conjunction with a confirmed letter of credit; this is just a letter of credit that does not have a second bank guarantee and is more standard.
Back-to-Back Letter of Credit
In a back-to-back letter of credit, there are three parties involved, not including the issuing bank. The seller will get the letter of credit from the buyer, but then the seller will transfer that letter of credit to its supplier.
The issuing bank of the back-to-back letter of credit will issue the letter, which can be transferable to the first beneficiary, who then can transfer it to its customer or secondary beneficiary. Once transferred, the issuing bank will issue a transferred letter of credit, which is identical to the first letter of credit. The first beneficiary, who has the original letter of credit, gives the newly transferred letter of credit to the second beneficiary.
Why Use Different Types of Letters of Credit
Every business is different, and every transaction is unique, which is why there are multiple types of letters of credit available to choose from. Letters of credit ensure that you are getting paid on time and the buyer is receiving their goods or services.
They not only allow the payment portion of a transaction to go smoothly but also help to build trust between the buyer and seller while hammering out complicated details, such as any clauses that need to be guaranteed.
Having a letter of credit is important in facilitating new business between companies, especially international ones. Without a letter of credit, businesses may be hesitant to purchase goods from a new company, but with one, they are able to trust that they will receive payment on time.
Expand Your Business Opportunities with Letters of Credit
Letters of credit allow your business to grow and trade with new companies, both domestic and foreign. With a letter of credit in hand, you can be assured you will receive payment or goods without worry and negate any risk. If you are interested in learning more about the types of letters of credit available to your business, reach out to SouthEast Bank to talk to a qualified lender.
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Information contained in this blog is for educational and informational purposes only. Nothing contained in this blog should be construed as legal or tax advice. An attorney or tax advisor should be consulted for advice on specific issues.