Letter Of Credit
Definition:
A letter of credit (LC) is a document issued by a bank on behalf of a buyer to a seller, guaranteeing payment to the seller if the buyer fulfills the terms of the contract.
Key Features:
- Issued by a bank: A letter of credit is issued by a bank on behalf of the buyer.
- Guarantees payment: The bank guarantees payment to the seller if the buyer fails to pay according to the contract.
- Conditions of payment: The letter of credit specifies the conditions under which payment will be made, such as the payment deadline and the documents required.
- Documents required: The buyer is required to provide certain documents, such as invoices and bills of lading, to the bank in order to claim payment.
- Creditworthiness: The bank assesses the buyer’s creditworthiness before issuing the letter of credit.
- Fees: Banks typically charge fees for issuing and administering letters of credit.
Types of Letters of Credit:
- Sight draft: Payment is required upon presentation of the documents.
- Documents draft: Payment is required within a specified time frame after presentation of the documents.
- Time draft: Payment is required at a specific time in the future.
Uses:
- International trade: Letters of credit are commonly used in international trade to facilitate payment between buyers and sellers.
- Government contracts: Letters of credit are sometimes used in government contracts to guarantee payment.
- Export financing: Letters of credit can be used as part of export financing arrangements.
Advantages:
- Protection for sellers: Letters of credit provide protection for sellers against non-payment.
- Convenience for buyers: Letters of credit allow buyers to make payments without having to provide collateral.
- Control over payment: Banks can control the payment process and ensure that payments are made on time.
Disadvantages:
- Cost: Letters of credit can be expensive to obtain.
- Time delays: Processing time for letters of credit can be longer than traditional payment methods.
- Credit risk: The bank’s credit risk is transferred to the buyer.
FAQs
What is meant by a letter of credit (LC)?
A letter of credit (LC) is a financial document issued by a bank that guarantees a buyer’s payment to a seller. It ensures that the seller will receive payment once specific conditions outlined in the LC are met, typically used in international trade.
What is the LC payment method?
The LC payment method ensures the seller receives payment from the buyerโs bank once they submit the required shipping and transaction documents. The bank reviews and verifies the documents before releasing payment to the seller.
What is the difference between an LC and a bank guarantee (BG)?
An LC guarantees payment to the seller as long as they meet specific conditions, whereas a bank guarantee ensures compensation to the buyer or seller if the other party fails to fulfill their obligations. LC focuses on the transaction, while BG covers a party’s failure to perform.
Who issues a letter of credit?
A letter of credit is issued by the buyer’s bank upon request. The buyer arranges for the bank to issue the LC, providing assurance to the seller that payment will be made as long as the transaction terms are fulfilled.
