Letters of Credit

A standard, commercial letter of credit (LC) is a document issued by a financial institution, used in trade finance, which provides an irrevocable payment undertaking against submission of documents and compliance of other conditions as per LC terms.

Letters of credit are used primarily in international trade transactions, for deals between a supplier in one country and a buyer in another.

Elements of a Letter of Credit:

  • A payment undertaking given by a bank (Issuing Bank)
  • On behalf of a buyer (Applicant)
  • To pay a seller (Beneficiary) for a given amount of money
  • On presentation of specified documents representing the supply of goods
  • Within specified time limits
  • Documents must conform to terms and conditions set out in the letter of credit
  • Documents to be presented at a specified place


How It Works:

 

  • The Buyer and Seller enter into a sale contract and a PO/PI is issued by the buyer in favor of the supplier
  • The Buyer (Applicant) arranges a LC in favour of the Seller (Beneficiary) covering the deal
  • The Seller ships the goods and submits all the documents in terms of the LC within the validity of the LC and complies with all the other terms and conditions of LC
  • The Seller is paid by the LC opening bank


Benefits of an LC to the Buyer:

  • The Buyer is able to buy the goods and pay for them after shipment of goods
  • There is no financial risk to the Buyer if the goods are not shipped after the order is placed
  • The LC issuing Bank extends its credit to the Buyer which helps him to buy from new vendors
  • No funds are blocked until documents are received after the shipment, thereby improving cash flow
  • The Buyer is also assured that goods are shipped in time, failing which there is no liability to pay


Benefits of an LC to the Seller:

  • The Seller does not run the risk of cancellation of the order as the LC is irrevocable
  • Payment is assured after shipment on submission of documents complying with the terms of the LC and other conditions. So he does not run the risk of non- payment after the shipment
  • It helps to raise finance for production of goods thereby meeting working capital requirements