Making commercial letters of credit work for your business
When it comes to cash flow overseas, security is in the details. Learn how to craft a transaction that makes sense for your business.
Engaging in international trade can be a complex move for businesses, particularly if you are expanding to new regions or working with unfamiliar partners. Financial tools exist to make the process less risky — for both importer and exporter. A commercial letter of credit is one of the most common tools used to conduct business abroad.
What is a commercial letter of credit?
A commercial letter of credit is a tool used to facilitate international trade. Once the parties agree to a payment via a L/C, the buyer will approach their bank for the issuance of a L/C in favor of the exporter. A L/C enhances a buyer’s creditworthiness by providing an irrevocable undertaking to make a payment to the seller from a neutral third party — provided the seller has shipped the contracted goods, performed the services, and provided the required documentation in compliance with the L/C. The applicant or buyer is not a party to the L/C. If the applicant should declare bankruptcy or simply refuse to pay, the issuing bank remains obligated to honor the L/C upon their receipt of complying documents.
The letter will typically route through an advising bank in the beneficiary’s country, which will authenticate and relay the L/C to the exporter. The applicant will then be required to reimburse the issuing bank upfront or with a line of credit.
A commercial letter of credit benefits both buyers and sellers, but the details of each overseas transaction can differ on a case-by-case basis. Fortunately, some stipulations can be included in a commercial letter of credit to tailor it to the specific needs of the parties involved.
Confirmed versus unconfirmed letters of credit
A confirmed letter of credit nominates another bank — sometimes the advising bank — to act as the “confirming bank.” The confirming bank provides the exporter with its own undertaking of payment, in addition to the issuing bank. A confirmed letter of credit adds another layer of security for exporters and is often used when the security provided by an unconfirmed letter of credit is deemed insufficient.
Note that confirmed letters of credit are more costly. Confirming banks will charge fees that are typically paid by the sellers, however, the buyer, or both parties, can share the expense.
Sight versus time letters of credit
Sight letters of credit require banks to pay the sellers immediately upon receiving complying documents. Exporters benefit by improving their cash flow, allowing them to receive payment before their shipments have necessarily been delivered to their buyers.
Time letters of credit, on the other hand, are payable only after a stipulated period of time. The payment is due at the maturity directed in each L/C. Often, a seller can shorten the Days Sales Outstanding (DSO) by requesting a prepayment, at a discount to the presentation’s value. The time commitment fee plus the discount fee is often for a lower interest rate than would come with a traditional loan. This benefits the buyers, who can extend their Days Payable Outstanding (DPO) before they’re required to pay the issuing bank back.
Transferable versus non-transferable letters of credit
Assume a seller needs different raw materials to complete an order for their buyer. The seller would prefer to retain their cash and credit lines until such time as they receive a payment from their buyer. The beneficiary of a transferable L/C can offer their suppliers the security of a L/C payment by transferring all, or a portion of the L/C’s value, to another beneficiary or beneficiaries. Depending on the type of transfer requested, the original beneficiary will receive the opportunity to substitute their own drafts and invoices to replace those of a transferred beneficiary. Once the complying documents are presented, payment will be made to all beneficiaries.
Commercial letters of credit are one of the most commonly used mechanisms to facilitate international trade. But the details contained within a commercial letter of credit can determine how much your business benefits.
Wells Fargo offers foreign exchange hedging products and foreign currency management solutions through Wells Fargo Bank, N.A., which is a swap dealer registered with the Commodity Futures Trading Commission and a member of the National Futures Association. This information does not constitute investment advice or a recommendation or opinion to enter into any foreign exchange or other transaction.