A standard, commercial letter of credit (LC) or L/C 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. Letter of Credit is issued at the request of buyer (Applicant) in favor of supplier (Beneficiary) by the applicant’s bank (Issuing Bank). This service eliminates the risk of non-payment in international trade transactions.
How It Works:
- The Buyer and Seller enter into a sale contract and a PO/PI is issued by the buyer in favor of supplier.
- The Buyer (Applicant) arranges a LC in favor 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 Letter of Credit opening bank.
Benefits 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 L/C 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 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.