Definition of Letters of credit
“Letters of credit are a guarantee from a financial provider that they will make a payment to a seller, once certain criteria are met. Letters of credit are used to cement trade relationships and minimise risk, particularly when trading internationally.”
Letters of credit can help you forge strong relationships with suppliers, and ensure that trust is established quickly. Post-recession, suppliers are more cautious about offering credit to buyers and, particularly if you are trading internationally, there can be a funding gap between receiving goods and being able to send full payment.
That’s where letters of credit can be helpful as a trade finance tool, which establishes better relationships and enables you to trade freely with less concerns about payment times or creditworthiness.
How letters of credit work
Normally a decision to offer a line of credit will be based on an assessment of your ability to pay. Once a line of credit has been agreed with you, letters of credit will be on the basis of each individual transaction. If you have agreed a sale with another party, lenders will need to understand the terms that need to be fulfilled before the seller can receive full payment, and document these in a ‘letter of credit’. Essentially, this guarantees that once the documented terms have been fulfilled, the seller will be paid, so they are relying on a lender’s creditworthiness rather than yours.