How a Letter of Credit Can Boost Profitability
One of the most important things to negotiate before closing on an export sale is how payment will be made. Short of asking for payment in advance, securing payment with a letter of credit is the next best option. Sure it’s a little more expensive–typically 1/8 of 1 percent of the total transaction price plus incidental fees related to any amendments that might have to be made–but it’s worth it to know you have a secure method of payment. As we all can agree, there’s no price tag for peace of mind!
How a Letter of Credit (L/C) Works
The parties to a letter of credit transaction are as follows:
1. The buyer. That’s your customer. He or she opens the letter of credit.
2. The opening bank. This bank normally issues the letter of credit, so it is sometimes referred to as the “issuing bank.” It assumes responsibility for the payment on behalf of the buyer.
3. The paying bank. This is the bank under which the drafts or bills of exchange are drawn under the credit. A paying bank in an L/C transaction might also act as the negotiating bank, advising bank or confirming bank, depending upon what responsibilities it accepts.
4. The seller. That’s you, the exporter, in this case–the beneficiary to whom the credit is issued to.
The L/C Process
Once you and your customer agree on payment by letter of credit, it is the customer’s responsibility to take your pro forma invoice to her bank and open the L/C in your favor. Once the opening bank has all the appropriate information from the customer, it advises you, the seller, that the L/C has been opened. Oftentimes this will be done by cable to the paying bank. Your bank then forwards that information to you. The letter of credit is final and subject to correction only for errors in transmission. That’s why accuracy in all details of your letter of credit is critically important.
Most Commonly Used Letter of Credits
There are two most common types of letter of credits that are used: irrevocable and revocable.
An irrevocable letter of credit is a commercial document issued by a bank at your customer’s request in your favor. Once issued, it cannot be modified without both parties’ consent. It’s the most secure method of payment and one that I suggest you use as often as possible.
A revocable letter of credit is a commercial document issued by a bank at your customer’s request in your favor, which can be modified without both parties’ consent at any given point in time. Unfortunately, you cannot rely on this L/C since the bank is under no obligation to cover the L/C if your customer defaults. You may as well just run a credit check on a customer and ship open account. It’s almost the same risk.
L/C Payment Timetables
You may extend varying payment terms with your letter of credit, ranging from a demand for payment on sight–as soon as goods are delivered to your customer through evidence prescribed documents such as an original bill of lading (BOL)–to an allowance of up to 180 days before payment is due.
Boost Profitability on an L/C Transaction
Here’s the best-kept secret on how to boost profits for your business with an L/C while satisfying your customer’s payment preference. Please note: I strongly recommend you consult with an experienced international banker before you take action.
You can elect to receive payment at sight against an L/C to boost cash receivables and profits. However, this method hurts your customer’s pocket book because he has not, at this point, had a chance to sell the goods you just sold to him. That can be a fairly big cash outlay for a customer. Alternatively, you can elect to receive a deferred payment, say after 180 days, to allow your buyer a grace period for payment. In that case, there’s no boost to your profits or bank account until six months have passed, but your customer is happy that you’ve given him more time.
Surprisingly, there is another option that can benefit both seller and buyer. Once the LC opening bank has accepted the documents and drafts you presented, the opening bank may discount and pay you, the beneficiary, in advance before the maturity date (a fixed or determinable future date) of the L/C provided you indicate as such in the agreement. What that means is this: You can allow your customer 180 days after sight of the original BOL to pay his bank, but you collect the money involved in the transaction immediately. This is called a discounted payment.
The discount interest rate for the early payment varies anywhere between 6 percent and 18 percent of the total transaction bill. It would be your responsibility as the seller to absorb it, but it is generally based on the risk of the country of LC opening bank and reputation of the LC opening bank. The end result is you get cash fast from the export sale and your customer gets the 180 days he needs to pay.
Letters of credit, especially export letters of credit, play a vital role in international trade between a buyer in one country and a seller in another.
This article is by no means a panacea on all varying types and uses of letter of credits, but it should serve as a primer for learning about the two most important ones.
Laurel Delaney runs Chicago-based GlobeTrade.com, a leading management consulting and marketing solutions company dedicated to helping entrepreneurs and small businesses go global. She is the creator of The Global Small Business Blog, ranked No. 1 in the world for entrepreneurs and small businesses interested in going global. She is currently at work on a new book on exporting to be published February 2014. You can reach Laurel via email.