Letters of Credit, by their nature, are designed to be initiated by purchasers. They are used in the place of paying cash upfront for goods being purchased. However, a properly drawn Letter of Credit includes stipulations that benefit both the purchaser of the goods and the supplier.
What is a Letter of Credit?
A Letter of Credit (LOC) is a formal document, issued by a financial institution, that acts as a promise to pay. It's a popular form of payment when:
- a business is purchasing goods and wants to minimize the risk in the transaction
- a supplier demands payment upfront and the purchaser wants an alternative to cash payment
- a purchaser, dealing in international trade, wants to bridge the differences in foreign currencies, international banking policies, import/export laws and multiple time zones
Instead of transferring cash in advance to purchase goods, the Letter of Credit sets out the terms under which payment will be made. This can include such things as the due date, quantity and location of goods to be delivered. It often allows a period of time after delivery for the purchaser to inspect the goods. The LOC sets out the documents that a supplier must present to their bank in order to receive payment.
How a Letter of Credit protects the purchaserÉ
- Reduced risk: Especially when bridging the barriers of distance, currency and language, the LOC minimizes the risk when dealing with a new supplier by stipulating the terms that must be met before payment is made.
- No surprises: The LOC provides the purchaser with the ability to document their expectations so that there are no surprises for the purchaser or supplier during the transaction.
- Financial institutions act as impartial third party: Both financial institutions (the purchaser's issuing ÒbankÓ and the supplier's advising ÒbankÓ) act impartially, basing their terms for payment on the stipulations within the LOC and the documentation presented by the supplier once shipment is made.
How a Letter of Credit protects the supplierÉ
- Assurance of payment: Provided the supplier meets the requirements set forth in the LOC, the LOC provides assurance that they will be paid.
- Payment from their local financial institutions: The LOC can be honoured by the bank or financial institution of their choice.
If your company purchases goods through large transactions or international trade, consider using a Letter of Credit in lieu of payment upfront. You'll have less strain on your cash flow and stronger assurances that the product you ordered will be delivered as you expect.
If you're a supplier, consider accepting Letters of Credit to help build your business, where cash upfront isn't possible or practical due to international and currency differences or your ideal customer's payment policies.
In the end, with a properly drawn Letter of Credit, both purchaser and seller will benefit.