What is a letter of credit?
A letter of credit is a letter from a bank guaranteeing that a buyer (for example, your customer) will pay a seller (you) on time and for the correct amount. If the buyer cannot pay, then the issuing bank will be required to cover the full or remaining amount of the purchase. So, you could summarise the letter of credit definition by saying that it’s a bit like having a co-signer on a loan.
What does a letter of credit cost?
The amount required varies according to several factors, including the company’s credit score, transaction history.
Risky companies may be required to put up 100 percent of the purchase price to secure a letter of credit, while established ones with excellent credit history may be asked for as little as one percent of the total sales.
Advantages of a letter of credit:
- Provides security for both seller and buyer.
- Issuing bank assumes the ultimate financial responsibility of the buyer.
- Guaranteed payment allows the seller to borrow against the full receivable value of the transaction from the lender.
Disadvantages of a letter of credit:
- Usually covers single transactions for a single buyer only.
- Expensive, tedious, and time-consuming in terms of absolute cost, working capital, and credit line usage.
- Additional need for security and collateral to satisfy the bank’s coverage terms for the buyer.
- Lengthy and laborious claims process involving more paperwork for the seller.
Letter of credit compared to trade credit insurance:
if your customer fails to pay you or is late in paying you, the insurer indemnifies a proportion of your receivables. This guarantees efficient protection of your cash flow in case of unforeseeable events and is the most reliable way to deal with insolvency risk.
- Trade credit insurance is a continued partnership, not just one bank-assisted transaction. It covers multiple transactions and multiple customers, unlike LOC.
- Trade credit insurance offers a similar guarantee of payment as a letter of credit but is generally cheaper than what a letter of credit costs.
- You create a smoother transaction rather than presenting the customer with the additional cost and bother of obtaining a letter of credit.
- With trade credit insurance, knowing you will receive payment means you have the freedom to offer more favorable payment terms as compared to letters of credit.
Trade credit insurance also offers predictive protection and access to a global network of experienced risk analysts and finance professionals, so you can make better-informed business decisions.
