When to use a letter of credit
Considering the options before deciding to use a letter of credit for an overseas transaction
Exporting can provide businesses with extensive trading opportunities but can also present some challenges, particularly in the area of finance. One of these challenges is a mutual lack of trust between buyer and seller.
Buyers on the one hand may be afraid of paying up front for goods due to the risk of them not being delivered and the sellers on the other hand may be uncomfortable supplying the goods for fear they may not get paid. A letter of credit is the most commonly used solution to this issue. Payment is guaranteed to the seller providing documents called for, by the buyer, are presented in order and within the agreed timeframe.
Read more about how to manage the risks of exporting.
Exporters - deciding whether to ask for a letter of credit
Think carefully about whether or not you need to ask an overseas customer for a letter of credit. Some important things to consider include:
- National Exchange Controls - does the country you're exporting to have any?
- Costs - does the value of the order justify the bank charges and extra costs involved, and who pays these costs?
- The customer's creditworthiness - do they have a track record with you?
- Risks associated with the country you're exporting to - is it politically stable with a good reputation as an international trading partner?
- Normal trading practices - is it standard practice for exporters to use letters of credit when trading with that country, and/or in that particular commodity?
- Available advice and guidance - banks may recommend using of a letter of credit in certain trading situations regardless of other factors, while credit insurers sometimes insist on it.
Give some thought to alternative arrangements, such as credit insurance, export factoring or cash in advance terms.
If you do decide that a letter of credit is the best option you'll need to consider which type of letter to use. A 'confirmed and irrevocable' letter of credit is the most secure type.
It's wise to have a clear policy in your business about when to consider using a letter of credit. Reviewing your policy on a regular basis will help you avoid using them unnecessarily and possibly putting off would-be customers.