What is the purpose of a letter of credit?

A letter of credit is a document that forms a relationship between a lender, a customer requiring funding and a supplier. When a letter of credit is issued it acts as a guarantee that the supplier will be paid once all the conditions specified within the document have been met.

Typically, a letter of credit would be used for an international agreement where the customer and the supplier have no trading history or relationship. However, it can also be used when transactions are between 2 business that are both located in the UK.

The benefits for an international trade

An importer of goods from one country to another can use a letter of credit as a guarantee that they will receive the items being purchase. Payment is only made once proof of shipment has been received. This gives the customer full peace of mind that the sale is legitimate, they also protect their cash as no advance payments or deposits are required. Finally, by using a letter of credit full credibility for both the importer and the exporter is shown meaning the agreement will be a successful one.

If we focus solely on the exporter, then the letter of credit offers insurance that payment will be made. For additional security, if there are problems with payment being made by the customer, the financial company who have issued the letter of credit will cover the total amount of money outstanding.

Who need to be involved when creating a letter of credit?

There are 3 parties involved in this process:

1. The customer – a company looking to purchase equipment, machinery or stock from a business that they have little or no history with. Can also be known as the importer.
2. The supplier – a company who is willing to sell equipment, machinery or stock to new customers. Can also be known as the exporter.
3. Financial company – a financial institution that is approved to set-up agreements involving letter of credits. This can include both Banks and other money lending companies.

How will a letter of credit work?

There are 3 simple steps:

1. A letter of credit will be developed to outline specific conditions that need to be met by a supplier before a customer provides payment.
2. A lender (who typically will be working for the customer) will monitor and ensure all agreed conditions are met by the supplier.
3. When all conditions are met, the money is released to the supplier and the agreement is completed.

If you have any questions or would like to know more about the benefits of a letter of credit our team would be happy to help.

Please call us on 01993 706403 or e-mail enquiries@ngifinance.co.uk.