Obtain a Letter of Credit to Support Your Business- All You Need to Know

Over time, we have observed that in the world of global commerce, one of the many obstacles businesses encounter is securing the financial support required for growth. Whether you're a small startup looking to expand your horizons or a well-established corporation engaged in cross-border trade, having access to reliable financial instruments is paramount to your success. This is where a Letter of Credit (LC) steps in as a lifeline for businesses engaged in international transactions.

Now for those of you new to this concept of a letter of credit, sit tight. In this post, we will simplify the process of obtaining a Letter of Credit, and throw light on how it may be a potent tool to support your business endeavors. Let’s delve in!

What is a Letter of Credit?

A letter of credit, often called LC, is a financial tool that is frequently used in international trade to enable safe and reliable transactions between buyers and sellers who may not already be acquainted or who conduct business in different jurisdictions. It acts as a guarantee from a bank or financial organization assuring that a seller (the beneficiary) will be paid for goods or services given to a buyer (the applicant), as long as the terms and conditions stated in the LC are met.

Types of Letters of Credit

Before you go ahead to obtain a letter of credit, know that there are numerous types of Letters of Credit (LC). Choosing the type of letter of credit to use depends on a number of factors, including the nature of the trade, the degree of risk, and the preferences of the parties involved. Here are some common types of LC:

Commercial Letter of Credit (CLC)

This is the most commonly used type of LC in international trade. It is also referred to as an import/export letter of credit. Commercial Letter of Credit is used for the purchase of goods or services, providing payment security to both the buyer and the seller. 

Standby Letter of Credit (SBLC)

Standby letter of credit serves as a secondary payment guarantee in case the buyer (debtor) fails to fulfill their financial obligations. SBLC is often used in situations where there is a risk of default, such as construction contracts, loan agreements, or lease agreements. SBLC is drawn upon by the beneficiary (e.g., the seller) when the buyer defaults on their payment.

Revolving Letter of Credit

A Revolving Letter of Credit is the type of letter of credit that provides a renewable line of credit for a specified period to facilitate multiple transactions between the buyer and seller. It offers flexibility in terms of both financing and the number of transactions allowed within the validity period of the LC.

Confirmed Letter of Credit

In a confirmed LC, a second bank (the confirming bank) adds its own guarantee to the letter of credit, in addition to the issuing bank's guarantee. Confirmed letter of credit is mostly used when the creditworthiness of the issuing bank is in question. It offers an extra layer of security for the beneficiary. 

Red Clause Letter of Credit

A red clause letter of credit includes a special clause allowing the beneficiary to receive an advance payment (usually a percentage of the LC amount) before shipping the goods. The idea is to provide financial assistance to the seller for the initial production or purchase of goods.

Revocable Letter of Credit

A revocable letter of credit can be changed or canceled by the issuing bank without notice to the beneficiary. Revocable LC is rarely used in international trade because it provides little security for the seller.

Irrevocable Letter of Credit

An irrevocable Letter of Credit cannot be changed or canceled without the agreement of all parties involved. It provides greater security for both the buyer and the seller, making it the preferred choice for most international trade transactions.

How Letter of Credit Work

The way a letter of credit works depends on the type of letter of credit and the businesses involved. However, to help you understand the concept and how to obtain a letter of credit, here is the general way it works:

• Issuance: The buyer (applicant) approaches their bank or a financial institution to request the issuance of an L/C in favor of the seller (beneficiary). The L/C specifies the terms and conditions of the trade, including the amount to be paid, the date of payment, and any other relevant details.
• Confirmation: In some cases, the seller asks for the LC to be verified by their local bank or a more reputable international bank. The bank reviews the terms of the transaction and the buyer's creditworthiness This adds an additional layer of security for the seller.
• Presentation of Documents: Following the issuance of the LC, the seller ships the products or renders the services in accordance with the contract and creates the required documentation (such as invoices, bills of lading, and certificates of origin). Note that all is based on the terms of the  LC.
• Document Examination: The advising bank (seller’s bank) reviews the documents received from the seller to ensure they conform to the terms of the LC. If the documents meet the requirements, the advising bank forwards them to the issuing bank.
• Payment: Upon receipt of the complaint documents, the issuing bank makes the agreed-upon payment to the seller. If the documents do not conform to the terms of the LC, the issuing bank may request corrections from the seller or negotiate discrepancies.
• Delivery of Goods: In some cases where the payment has to be done before claiming possession of the goods, the issuing bank releases the documents to the buyer once payment is made. The buyer uses these documents to take possession of the goods from the carrier. The LC is considered fulfilled and closed once the transaction is complete.

10 Steps to Obtain a Letter of Credit

By now, you will agree with us that obtaining a Letter of Credit for your business can be a valuable financial tool to facilitate international trade and establish trust with your business partners. But how do you go about this? Here are the steps to obtain a letter of credit:

Step One: Identify the Need for an LC

To decide if a letter of credit is necessary for you, evaluate the needs of your business and your transactions. I mean; Take into account factors like the complexity of your transaction,  the trustworthiness and credibility of your trading partner, and the need for payment security. Don’t just jump into obtaining a letter of credit if not needed.

Step Two: Partner with a Corporate Service Provider

Obtaining a letter of credit can be tasking. Instead of committing a lot of your time to the process of obtaining an LC, you can outsource this task to a corporate service provider, while you focus on the other aspects of your business. For example; here at FirmEU, we can help you determine the type of letter of credit that is best for you and also help you reach out to the best financial institution who you can work with. In fact, we have a large number of banks across jurisdictions that we have worked with. Contact us today to learn more and get started!  
If you choose to go through the process of obtaining a letter of credit yourself or just want to learn more while we handle it for you, read on.

Step Three: Choose the Right Type of LC

Decide which type of L/C suits your transaction. As we have shown you in the previous section; commercial or standby, revocable or irrevocable. This choice will depend on the nature of your trade and the level of commitment required. Got it?

Step Four: Select and Connect with a Reputable Financial Institution

Choose a reputable bank or financial institution that offers letter of credit services. To do this, you have to first research properly. Look for a bank that has handled LCs successfully in the past and has experience in foreign trading. When you find the best financial institution, reach out to the bank to discuss your intention to obtain a letter of credit. Set up a meeting with a relationship manager or LC specialist to understand their specific requirements and procedures.

Step Five: Prepare Necessary Documentation

Gather all the required documentation, which typically includes:

• Proforma invoice or sales contract
• L/C application form
• Financial statements of your business
• Bank references
• Trade references
• Any other documents specified by the bank or relevant to your transaction

Step Six: Complete the L/C Application

Accurately fill out the L/C application form that the bank will provide. Make sure that every detail is in line with the terms of your transaction and the related documentation. Furthermore, check your L/C application thoroughly for accuracy and completeness. Once you're satisfied, send it to the bank along with all the necessary paperwork. Keep copies of all documents for your records, don't forget.

Step Seven: Bank Evaluation and Approval

The bank will evaluate your application and documentation. They may perform a credit check and assess the risk associated with your transaction. This process may take some time, so be prepared for a waiting period. Here at FirmEU, we fast-track this process for our clients.

Step Eight: Negotiate Terms and Conditions

Now that you have been able to establish a collaboration with a bank, work closely with the bank to negotiate the terms and conditions of the LC. Ensure that the terms and conditions are in line with the needs of your transaction and the expectations of both parties involved.

Step Nine: Receive and Activate the Letter of Credit

Once your application is approved and all terms are agreed upon, the bank will issue the letter of credit in your favor. You will receive the LC document along with any instructions on how to use it. Follow the instructions provided by the bank to activate the LC. Typically, this involves presenting the letter of credit to your trading partner, who will then initiate the transaction according to the terms specified.

Step 10: Close or Renew the LC

Once the transaction is completed, you can close the LC. If you have ongoing trade relationships, you can also consider renewing or extending the LC for future transactions.
NOTE: Throughout the transaction, carefully monitor the progress of the LC to ensure compliance with its terms and conditions. Communicate any changes or issues promptly with the bank.

Benefits of Using a Letter of Credit for Business Transactions

Using a Letter of Credit (LC) for business transactions has several advantages for both buyers and sellers, especially when dealing with international trade or complex transactions. Here are some significant benefits:

For Buyers (Importers)

1. Payment Security:

• Using LC ensures that the seller will receive payment only if they meet the terms and conditions of the L/C.
• When you obtain a letter of credit, you are Confident about the quality and condition of goods or services before making payment.
• Reduced risk of fraud or non-performance by the seller.

2. Trust Building:

• LC establishes trust with international suppliers or sellers.
• Using LC demonstrates your commitment to fulfilling payment obligations.

3. Risk Mitigation:

• A Letter of credit Mitigates currency exchange rate risk as payment is typically in the buyer's currency.

4. Legal Protection:

• LC serves as a legally binding document that provides clear terms and conditions for the transaction.

5. Access to Financing

• LC enhances working capital management by delaying payment until goods are received
• Using LC allows buyers to negotiate favorable credit terms with their banks.

For Sellers(Exporters)

1. Payment Guarantee:

• LC is the guarantee of payment, reducing the risk of non-payment or payment delays.
• Minimization of credit risk associated with the buyer.

2. Trust Building:

• LC builds trust with international buyers or importers.

3. Risk Mitigation:

• LC serves as Protection against political or economic instability in the buyer's country.

4. Legal Protection:

• With LC, sellers have legal recourse in case of non-payment or disputes.

5. Access to Global Markets:

• LC gives sellers access to a broader customer base in the international markets.
• By accepting LC, you gain the ability to compete in markets where LC is common practice.

Conclusion

Throughout this discussion, we've explored the essential steps to obtain a Letter of Credit (LC) for your business transactions, as well as the substantial benefits. As we conclude, it's important to emphasize the significant advantages that LC brings to businesses engaged in international trade. If you haven't already considered incorporating LC into your transactions, now is the time to explore this financial instrument. By doing so, you can unlock a world of opportunities, enhance your financial security, and establish yourself as a trustworthy and reliable partner in the global marketplace.