Benefits of a Letter of Credit

Sadie Keljikian, Express Trade Capital

If you import goods, your suppliers probably require that you provide a deposit when you place an order. Suppliers usually request this for two primary reasons: (a) by getting an upfront deposit, the buyer is less likely to default on the remainder of the balance owed because the buyer would lose their deposit; (b) cash flow – the supplier needs funds to produce the goods and deposits are essentially interest free cash. Unfortunately for importers and wholesalers, deposits tie up and divert cash from day to day operations and other revenue generating or expansion oriented uses.

There are a few ways to avoid leaving substantial deposits or tying up cash to start production. First, you can minimize the size of your orders to avoid depleting your cash flow, but that would inhibit your growth. Big-box retailers generally place very large orders and offer significant opportunities to growing import businesses, so unless you find a way to accommodate these larger orders, it will be hard for you to attract big buyers. You can stagger orders so you don’t have to pay for everything all at once, but at some point, if you want to make substantial sales, you will have to find a way to finance large orders.

Another option to mitigate the burden of tying up cash for production upfront is to negotiate better terms with your supplier. If your company is large or you have a good history and/or trusted relationship with your supplier, you may be able to obtain goods on credit.  If you can get this option, use it.

A third option, if you want to take on larger orders and cannot obtain terms without leaving a deposit, is to offer your supplier a commercial Letter of Credit (“LC”) instead of a deposit. This gives your supplier a bank guarantee, which is an asset they can often use to obtain funding directly from their bank.

How do Letters of Credit work?

A letter of credit is a conditional assurance of payment provided to the supplier’s bank when the importer places an order. The LC is issued by a bank or financial institution on behalf of the buyer/importer and eliminates the need for a deposit by ensuring that both sides respect the conditions of the transaction.

Both parties benefit from an LC. The supplier becomes the beneficiary of a financial instrument they can use as collateral to obtain funding. They also obtain a bank guarantee of payment in addition to the buyer’s promise to pay for goods if all obligations are fulfilled. The buyer avoids the risk of tying up funds overseas and gets better control over the transaction. If the buyer uses a third-party provider, they can even obtain an LC without typing up collateral or cash lines with their own bank or financial institution.[1]

A commercial LC gives buyers comprehensive control over their importing process. It covers the cost of the goods themselves as well as shipping costs, allowing purchasers to keep their money until the goods are approved and shipped. While an LC may add to transaction costs, it grants the purchaser more control and more capital flexibility while giving the supplier more cash flow and some assurance of full payment.

Letters of credit benefit both the buyer and the supplier.

A letter of credit also serves as a layer of protection to ensure that you don’t waste time and money on an order that may not reach you on time or as expected. While your agreement with the supplier provides some degree of assurance that you won’t be left without your goods or money, there are no guarantees. Depending on the supplier, you may find yourself with faulty, defective, incomplete or late orders. Untrustworthy vendors can compound the issue by keeping your deposit regardless of their errors or inability to complete the orders as agreed. Without an LC, buyers can still take legal action against their supplier, but justice is uncertain and costly, particularly if the supplier is in another country.

In contrast, an LC requires collection of documents proving that the order is as expected and sent on time before the bank releases any payments to the supplier. The bank is basically acting as an escrow agent to ensure compliance by all interested parties. Thus, importers purchasing inventory overseas never need to worry about lost working capital due to failed or incomplete orders, and suppliers can still obtain the cash flow they need without burdening their customers.

Interested in discussing Letters of Credit or other trade financing and supply chain management solutions further?  Speak to one of our specialists.

One of the most important, often hard-won lessons is how to protect one’s self and one’s assets in transactional proceedings. Letters of credit are a safe, simple way to protect yourself and your purchase, especially in the case of international import/export agreements. You and your vendor are legally and financially protected, so you can even place orders from less-than-trustworthy vendors with confidence.

[1] Express Trade Capital specializes in issuing LCs on behalf of client without requiring cash collateral or deposits. We tie up and freeze our own lines on behalf of qualified clients undertaking verified commercial trade transactions.