When we talk about international business and safe payment for international trade, the very first thing banks mention is LC or Letter of Credit.
But several questions may come to mind, like what is a letter of credit and its advantages. Are there any risks or drawbacks?
Well, if it sounds like you, this article is for you. Here we have answered all the questions regarding LC and the advantages and disadvantages of a letter of credit for any business.
Let’s start with the basics..
What is a Letter of Credit (LC)?
An LC, documentary credit or letter of undertaking is a payment mechanism used for payment-settlement of international business. Modern-day banks meet international payments through an LC management System.
The opening of it by the applicant or importer ensures financing from a credit-worthy bank to the exporter to supply goods and products.
It provides more security during money transactions between an export and import business.
An LC ensures the following criteria and objectives:
- Issuing bank promises to pay mentioned amount through LC
- Payment has a specific timeline
- Transaction will be completed solely on documents presented
- Bank cannot deny the payment to the beneficiary if everything goes okay
The following documents are required to open an LC:
- Bill of Lading
- Airway Bill
- Commercial Invoice
- Insurance Certificate
- Certificate of Origin
- Packing List
- Inspection Certificate
What Are the Advantages and Disadvantages of Letter of Credit?
A Letter of Credit is very effective, and it guarantees the payment of a particular person under definite terms and conditions.
Let’s move forward with some more advantages and disadvantages of issuing an LC.
The Advantages
Safe International Transaction
The application of an LC is a very safe payment process during international trade. That is because only the authorized bank can open LC on behalf of the importer to ensure the payment of the seller’s goods.
Customizable Approach
It is a very customizable approach for both parties. Traders can customize terms and conditions according to their needs. They can add new requirements or include export and import-related clauses in it.
So, you don’t need to worry much about the documented clauses in the LC ( As you can customize them any time.)
Free from Credit Risk for the Seller
The buyer can go bankrupt while not completing the payment of the seller. As trading in an LC payment is entirely done by some documented rules and conditions, the bank is obligated to provide the money to the seller.
So, you are on the safe side if you are a seller.
Better Cash Flow and Planning
It helps the exporters to decide and plan financial modelling more accurately. The successful transaction of money will be helpful for the seller, and it will be beneficial for maintaining the constant cash flow of the business.
New Trade Relation
The introduction of a letter of credit in trading will open a new business horizon as it helps establish a new international trade relationship.
The Disadvantages
Additional Bank Service Fee
Opening a letter of credit is relatively costly on many occasions. Along with the LC opening charges, there are other annual bank services fees for the concerning parties.
Complex Process
The opening of the Letter of Credit is a little bit of a complex process. It also requires many necessary documents. So, it can also be very time-consuming.
Limited Time
The payment through the letter of credit needs to be completed within the fixed time. If there appears any mismanagement, complexity may arise for both the parties.
Other Risks of LC.
There are some kinds of risks and fraud issues related to LC. They are:
- Possibility of Misuse – Fraud Risk: Complex operating rules, notorious buyers and sellers can misuse the information
- Currency Risk: Risks of fluctuations of currency rate
- Risk of Default by Issuing Bank: Upon the default of issuing bank, there may arise some risk of payment
Key Takeaways
- There are two parties involved in LC
- LC is mainly open by the buyer/applicant /importer
- Bank open it for the applicant to ensure the money of the beneficiary or seller or exporter
- The beneficiary is in the overseas
- It is the safe and legal way of transaction
Final Thought
For a safe and secure international payment, business operation or customization flexibility and the proper maintenance of cash flow. The use of the LC can be very advantageous for making global trade easier.
On the other hand, there are some risks and complexity of processing LC. And if you want a modern-day solution, you can implement an LC management system.