What is Letter of Credit? How Does it Work?

As a Small and Medium Enterprises (SME) owner, do you find yourself constantly worried about meeting operational expenses like payroll, paying rents and debts? Sufficient working capital finance is necessary but often under-valued. Given this context, it becomes a primary reason for seeking SME loans.

Moreover, SMEs often accept numerous ways (such as cash, checks and wire transfers) of getting paid by clients. But have you just struck a deal with an international client and find yourself in unfamiliar territory? Are you on the lookout for a sure-shot way to ensure you get paid the dues?

Whatever the situation you are in, a letter of credit is sure to bail you out. Here is everything you need to know.

What is a Letter of Credit?

A letter of credit is a document issued by a financial institution guaranteeing that a buyer’s payment for a specific amount will be received by the seller within a stipulated period of time. It has emerged to be of great help in international trade due to geographical distance, country-specific laws and lack of personal relations between transacting parties. The financial institution acts as the mediator to ensure that the buyer is credit-worthy.

Types of Letters of Credit

A financial institution like Tata Capital offers two types of letters of credit, both for domestic and international transactions. These are:

1. Sight Letter of Credit- With this letter of credit in hand, any businessman can avail the necessary funds by presenting a bill of exchange along with it to the lender. This kind of letter of credit works faster than any other.
2. Usance Letter of Credit- This kind of letter of credit, also called acceptance/time credit, are drawn and payable after a certain period of time. For instance, a buyer purchases goods from a seller and receives them on the same day. The bill will be delivered along with the shipment, but the buyer shall have up to 30 days to make the payment. This pre-specified period is the usance of the bill.

How Does a Letter of Credit Work?

• Once a buyer and seller decide to get into the business, they decide on the price, quantity, date of receiving the shipment and all other terms and conditions. If the seller wants to be doubly sure about receiving the payment, a letter of credit becomes part of the contract.
• The buyer can obtain the letter of credit from any financial institution. This institution takes responsibility for paying the seller on behalf of the buyer. This requires an assurance from the buyer to the bank that he/she can fund the payment.
• The buyer’s financial institution forwards the letter of credit of that of the seller. After it has made a satisfactory review of the same, the letter of credit is sent to the seller. The seller rests assured with the confidence of receiving payment as long as the pre-decided conditions are met.

If used imaginatively, a letter of credit can also help secure working capital. It can prove especially helpful if you are not keen on taking an SME loan for the same. For instance, a letter of credit from the likes of Tata Capital comes with quick approvals, no need for extra collateral and finance for up to 100% of the value.