letter of credit

What is a Letter of Credit
and How Does it Help a
Business to Manage Finances?

October 14, 2022 • 175 views

When planning to establish  a business, it is imperative to understand and produce all kinds of financial documents that are required for smooth operations. A Letter of Credit is one such document that could come in handy if you are planning to expand your product portfolio and services by adding foreign-sourced products and services. 

What is a Letter of Credit?

A Letter of Credit (LC) is a document used by businesses that are engaged in foreign trade. The document acts as a letter of security or guarantee offered by financial institutions to exporters. In other words, a Letter of Credit is a financial instrument that is given by financial institutions to enterprises that deal with international trade, import, and export as a monetary guarantee, in case of late payment or default.

Many enterprises have business operations abroad. These enterprises often deal with unknown suppliers, which necessitates assurance of payment before proceeding with any business transaction. It is a letter of assurance or guarantee to purchasers and suppliers dealing in the sales of products and services. Letter of credit is essential for business loans.

How Does a Letter of Credit Work?

A Letter of Credit is used as a guarantee which is issued by a bank to secure timely payments by the buyer to the seller. The letter is issued to ensure payment of any dues within the said time limit. If the buyer fails to pay the amount to the seller on time, then the bank will pay the seller on behalf of the buyer.

Also read: Invoice Financing: What Is It and How Does it Work?

What are the Features of a Letter of Credit?

  • A Letter of Credit is issued against security or collateral. This may include bank deposits, fixed deposits, etc.
  • The bank will charge a certain fee for the Letter of Credit, depending on its type.
  • The bank and the buyer must abide by the guidelines issued by the International Chamber of Commerce (ICC) for any type of LC.
  • No goods and services are involved in the process, only documents are exchanged among the parties involved.
  • Details mentioned in the Letter of Credit include the name of the seller, amount, date, product name, quantity, and more.
  • The correctness of the mentioned details needs to be on point as the bank may deny the payment if they find any errors in the buyer’s name, product name, shipping details, etc.
  • As no goods and services are involved, the payment will not depend on defective goods and services.  

Which Documents are Required for a Letter of Credit?

The applicant needs to produce the below-mentioned documents for a Letter of Credit:

  • Correctly filled application form and passport-size photographs
  • KYC documents of the applicant, co-applicants, directors, partners, etc.
  • Certificate of Origin
  • Commercial invoice
  • Bill of Exchange
  • Buyer’s financial documents
  • Original copies of health and insurance certificates
  • Documents regarding packing, shipping, and transportation
  • Airway bills, cargo receipts, etc.
  • Official documents required by the buyer/seller’s country
  • Other related commercial documents

Now that you know how to get a Letter of Credit issued from a bank, make sure all the documents required for a Letter of Credit are accurate to get fast approval. As a part of best practices, ensure timely product delivery to all the guarantors mentioned in the letter. With the right kind of Letter of Credit, you can expand your product portfolio and services to far-off locales and grow your small business.

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