Definition
A Letter of Credit (LC) is a document issued by a bank or financial institution that guarantees a seller will receive payment from a buyer once the terms and conditions mentioned in the LC have been met. Basically, it serves as a promise to the seller that the buyer’s payment will be received on time and for the correct amount. If the buyer is unable to make payment, the bank is obligated to cover the full or remaining amount.
Key Takeaways
- A Letter of Credit (LC) is a document issued by a bank that guarantees payment from a buyer to a seller. It provides an assurance to the seller that they will receive their payment once they adhere to the conditions specified in the LC.
- In international trade, the use of LC minimizes risks associated with different laws and practices in foreign countries, fluctuating currency values, and delays in payment. This effectively gives a higher level of protection to both buyers and sellers.
- Two types of LCs are the irrevocable LC and the revolving LC. An irrevocable LC can’t be changed or cancelled without the agreement of all parties involved, providing a strong payment guarantee. A revolving LC is for regular shipments, allowing repeated use of one LC rather than issuing a new one for each shipment.
Importance
A Letter of Credit (LC) is important in international trade and finance for several reasons.
It serves as a financial vehicle that guarantees the payment from the buyer to the seller.
As an assurance document issued by the buyer’s bank, the LC reduces the risk involved in international business transactions, providing certainty that the seller will be paid for their goods or services.
This reduces the risk of non-payment, thus incentivizing trade and fostering trust between parties, especially in cases where the parties are dealing for the first time or where they operate across different jurisdictions.
Overall, by mitigating risk and enhancing trust, a Letter of Credit promotes and facilitates international business and trade.
Explanation
A Letter of Credit (LC) is primarily used in international trade where the dependability of unacquainted parties cannot be ascertained or is questionable. The main purpose of a LC is to provide a level of security to both parties in a transaction.
For the seller, they have the assurance that they will receive payment as long as they meet the specific terms and conditions set out in the LC. The bank issuing the LC acts as a guarantee that the buyer’s payment to the seller will be received on time and for the correct amount.
On the other hand, the buyer is protected as well, since the issuing bank will not release the payment to the seller until all delivery conditions have been met. This basically creates a secure and efficient payment mechanism where the interests of both parties are safeguarded.
As such, the LC acts as a crucial instrument for mitigating risks associated with international trade, offering a more secure method of handling transactions and ensuring smooth business transactions across borders.
Examples of Letter of Credit (LC)
International Trade: A US-based toy manufacturer wants to buy raw materials from a supplier in China. Because they’re in different countries with different laws and regulations, there’s a risk that one party may not fulfil their obligations. To mitigate this, the toy manufacturer’s bank issues a Letter of Credit in favor of the Chinese supplier. Once the supplier proves shipment of goods through the necessary documents, the bank will make the payment. This guarantees the supplier will be paid and the manufacturer gets their goods.
Construction Project: Say, for example, a property development company in Australia has been contracted to build a set of buildings in Dubai. The Dubai-based client will request a Letter of Credit from the Australian company’s bank to ensure they will have funds available to complete the project on time.
Agriculture Export: An Indian farmer agrees to sell a shipment of wheat to a distributor in Europe. However, the distributor wants assurance that the goods will be delivered as specified. The distributor’s bank can issue a Letter of Credit, promising to pay the Indian farmer when the wheat is shipped as per the agreed terms. This gives the farmer the confidence to ship their goods overseas knowing that payment is assured.
FAQs about Letter of Credit (LC)
What is a Letter of Credit (LC)?
A Letter of Credit (LC), also known as Documentary Credit, is a letter from a bank guaranteeing that a buyer’s payment to a seller will be received on time and for the correct amount. In the event that the buyer is unable to make a payment on the purchase, the bank will cover the full or remaining amount of the purchase.
What are the types of Letter of Credit (LC)?
There are several types of Letters of Credit, including Revocable LC, Irrevocable LC, Standby LC, Revolving LC, Sight LC, Usance LC, and Confirmed LC. These differ based on certain factors such as revocability, sight for payment, and confirmation requirement.
What is the purpose of a Letter of Credit (LC)?
LCs are often used in international transactions to ensure that payment will be received where the buyer and seller may not know each other and are operating under different laws and regulations. They also provide the seller with a guarantee that they will receive payment from the buyer if certain delivery conditions are met.
What is the process of issuing a Letter of Credit (LC)?
The issuance process of an LC involves multiple parties and several steps. It starts when a buyer and seller agree to use an LC as a payment method. The buyer then applies for an LC from their bank, and the bank then sends the LC to the seller’s bank, outlining the terms of the deal. When the seller meets these terms and presents appropriate documents, the issuing bank makes the payment.
Can a Letter of Credit (LC) be cancelled or amended?
The LC can be cancelled or amended only with the agreement of all parties involved, including the issuing bank, the confirming bank (if any), and the beneficiary. Any changes, such as the amount, the expiration date, or the terms and conditions, must be approved by all parties.
Related Entrepreneurship Terms
- Issuing Bank: The financial institution that issues the Letter of Credit at the request of an applicant or buyer.
- Beneificiary: The party in the transaction who is intended to benefit from the Letter of Credit – generally the seller or exporter.
- Sight Letter of Credit: A type of LC where the payment is made to the beneficiary immediately after the required documents are presented.
- Usance Letter of Credit: A LC where payment is made to the beneficiary a set number of days after the date of receipt of goods or presentation of documents.
- Confirmed Letter of Credit: A LC where a second bank provides a guarantee of payment to the beneficiary, in case the issuing bank is unable to fulfill its obligation.
Sources for More Information
- Investopedia: Provides in-depth articles explaining various financial topics including Letter of Credit.
- The Balance: Offers comprehensive guides on finance and career topics, including Letter of Credit.
- Corporate Finance Institute: This website includes detailed information on corporate finance topics, including Letter of Credit.
- Trade.gov: Offers insights and guides related to international trade and finance, including Letter of Credit.
