When businesses engage in transactions that cross state lines or international borders, trust between buyer and seller becomes essential. Buyers want to ensure they receive what they’ve paid for, while sellers want reassurance that payment will be made. This is where a financial tool called a Letter of Credit (LC) comes into play. Issued by banks or financial institutions, a Letter of Credit provides a reliable payment mechanism that benefits both parties in a commercial transaction.
Definition of a Letter of Credit
A Letter of Credit is a formal, written commitment issued by a bank on behalf of a buyer. It guarantees that the seller will be paid a specified amount, provided that the seller meets all the terms and conditions outlined in the LC. In essence, the bank substitutes its own credit for that of the buyer, assuring the seller that payment is secure.
This financial instrument is most commonly used in international trade, where buyers and sellers may not know each other well and are often located in different countries with different legal systems, regulations, and currencies.
How a Bank Letter of Credit Works
Here’s a simple breakdown of the process:
- Agreement Between Buyer and Seller – The buyer and seller agree on a transaction and determine that payment will be made using a Letter of Credit.
- Buyer Applies for the LC – The buyer applies for a Letter of Credit at their bank (the issuing bank), providing details of the transaction and documentation requirements.
- Issuing Bank Sends LC to Seller’s Bank
- Once approved, the issuing bank sends the Letter of Credit to the seller’s bank (the advising bank), which verifies its authenticity.
- Seller Ships Goods and Submits Documents
The seller ships the goods as agreed and submits the necessary documents (such as the bill of lading, commercial invoice, and packing list) to their bank.
- Bank Reviews and Pays – The advising bank forwards the documents to the issuing bank. If everything matches the terms of the LC, the issuing bank releases payment to the seller.
- Buyer Reimburses the Bank – The buyer then reimburses the issuing bank, often with pre-arranged terms or lines of credit.
Types of Letters of Credit
There are several different types of Letters of Credit, each designed for specific needs:
- Revocable vs. Irrevocable: Irrevocable LCs cannot be changed or canceled without the consent of all parties. These are standard in international trade. Revocable LCs, which can be altered by the buyer or issuing bank without prior notice, are rarely used.
- Confirmed LC: In this case, a second bank (usually in the seller’s country) adds its guarantee of payment, offering additional security to the seller.
- Sight LC vs. Time LC: A Sight LC means payment is made as soon as the required documents are verified. A Time LC (or Usance LC) provides for payment at a future date, giving the buyer some breathing room.
- Standby LC: Unlike traditional LCs used in trade, a standby LC serves as a secondary payment method—essentially a safety net if the buyer fails to fulfill the contract.
Benefits of a Letter of Credit
For both buyers and sellers, a Letter of Credit brings numerous advantages:
- Reduces Risk: Sellers are guaranteed payment if they comply with the LC’s terms, and buyers are protected from making payment before goods are shipped.
- Encourages New Trade Relationships: When entering a new market or working with a new partner, an LC provides peace of mind for both parties.
- Access to Financing: Sellers can use the LC to obtain working capital financing or discount the LC at a bank to improve cash flow.
Limitations and Costs
While Letters of Credit are powerful tools, they do come with some drawbacks:
Cost: Bank fees for issuing and confirming LCs can be substantial, especially for small businesses.
Complexity: The documentation requirements are strict. Even minor discrepancies can result in delayed payment or refusal to pay.
Credit Requirements: The buyer must have sufficient creditworthiness or collateral to obtain a Letter of Credit from their bank.
Factoring vs. Letters of Credit
While Letters of Credit are ideal for mitigating risk in large or international transactions, many small to mid-sized businesses may find them cumbersome or too expensive for domestic transactions. This is where invoice factoring becomes a more efficient solution.
Invoice factoring allows businesses to sell their outstanding invoices to a factoring company like American Receivable, giving them immediate access to working capital without waiting for customer payments. Unlike a Letter of Credit, there’s no need for complex documentation or bank guarantees—just a fast, streamlined solution to improve cash flow and fuel business growth.
Trust American Receivable
At American Receivable, we’ve been helping small and mid-sized businesses improve their cash flow for over 45 years. While Letters of Credit are important tools for certain transactions, we know that invoice factoring often provides a faster, simpler, and more affordable solution.
If your business needs reliable working capital to fund operations, meet payroll, or grow, American Receivable is here to help. Contact us today to learn how we can be your trusted partner in financial success.
Jack Stieber [email protected] 972-404-4726
Julie Adams [email protected] 800-297-6652
Brad Gurney [email protected] 972-404-4726
Dakota Stieber [email protected] 800-297-6652
