A bank or financial institution provides a letter of credit to a small business, which guarantees payment to someone else once the conditions of the letter are met. A letter of credit is a great way for a business to order inventory and access trade credit without reducing cash on hand until the goods are delivered. The recipient of this letter of credit can factor it with an invoice factoring company to access funds immediately.
How a Letter of Credit Works
A business applies for a letter of credit to use as a negotiable instrument. Once a lender approves the business’s credit, the issuer will then prepare a letter of credit for the business, which can present it to a vendor. The issuer will release the funds of the letter of credit once the vendor meets the conditions outlined in the letter of credit.
For example, a business needs to purchase inventory from an overseas supplier. The supplier is reluctant to produce goods before receiving payment, and the business doesn’t want to pay for the product before it’s delivered. To address this issue, the small business owners go to the bank and get a letter of credit, which pays out a certain sum to the manufacturer once goods are delivered.
The bank ensures there are sufficient funds and acts as a third party to the transaction to satisfy both parties. The supplier can produce with confidence now that it has the letter of credit, and the small business can rest assured that if the goods never arrive or are damaged, it won’t lose money. The supplier also has the option of factoring this letter of credit to access the capital sooner.
Types of Letters of Credit
While a letter of credit serves the same primary purpose of guaranteeing payment for services or products between two parties, there are multiple types. These letters of credit include commercial, standby, traveler’s revolving, irrevocable, and confirmed. Each one contains different nuances in the contract that may be required to get both parties involved to agree to the transaction.
Commercial Letter of Credit
This is the most common letter of credit. The issuer guarantees payment to the holder once the stipulated obligation is met. It doesn’t have any additional requirements or assurances for either party, and it’s typically the easiest type of letter of credit to access for small businesses.
Standby Letter of Credit
With a standby letter of credit, the issuer guarantees payment to a seller on behalf of its client in the event its client defaults. This is usually needed if a company has a history of missed payments, or the business is in a particularly high-risk industry like restaurants.
Traveler’s Letter of Credit
A traveler’s letter of credit is issued to travelers so that they don’t face the inconvenience and risk of traveling with huge sums of money on hand. It is a bank document that requests for another bank to pay the holder the amount that’s listed in the letter of credit. This is used when payments must be made in person or when business owners fly out to inspect goods on-premise.
Revolving Letter of Credit
A revolving letter of credit works like a typical letter of credit, only this time it’s singular issuance is meant to cover either a specific number of transactions or multiple transactions over a given period of time. This letter of credit is most common for repeat purchases like inventory in the retail industry.
Irrevocable Letter of Credit
An irrevocable letter of credit is a financial tool prepared by an issuing bank that guarantees payment for goods or services once conditions in the agreement are met. It is called irrevocable because the terms and conditions written in the letter aren’t subject to cancellation or amendment without the explicit consent of both the buyer and the seller.
Confirmed Letter of Credit
A confirmed letter of credit is a guarantee of payment to a provider of goods or services that has the backing of a second bank—that is to say, a second bank will cover the payment in the event the first bank fails to cover it. This letter of credit is rare and is usually reserved for very large companies.
A letter of credit is a commitment from a financial institution to a provider of goods or services, guaranteeing, on behalf of its client, that payment will be made once conditions are met. So, it’s a helpful financial instrument that minimizes the risks involved in doing business with companies whose creditworthiness is unknown.