LETER OF CREDIT

LETTER OF CREDIT
A letter of credit is basically a document issued by a bank guaranteeing a client's ability to pay for goods or services. A bank or finance company issues a letter of credit on behalf of a buyer, authorizing the seller to obtain payment within a specified timeframe once the terms and conditions outlined in the letter of credit are met. The letter of credit acts like an insurance contract for both the buyer and seller and practically eliminates the credit risk for both parties, while at the same time reducing payment delays. A letter of credit provides the seller with the greatest degree of safety when extending credit. It is useful when the buyer is not well known and when exchange restrictions exist or are possible.

PURPOSE OF LETTER OF CREDIT

In International trade, the buyer and the seller who are located in different countries may not know each other and hence many times the problem of Buyers Creditworthiness hampers the trade between the buyer and the seller. The main objectives of the buyer and the seller in any international trade and contradictory in terms of Buyer will always try to delay the payment while the seller would like to receive funds at the earliest. To mitigate this problem, Seller always request Buyer to arrange for a Letter of Credit to be issued by Buyers Bank. Upon issuance of Letter of Credit, the Buyers bank replaces its own Creditworthiness to that of the Buyer, it undertakes to reimburse the Seller for the value of the Letter of Credit Irrevocably provided two underline conditions are fulfilled by the Seller: 1.All the documents stated in the LC are presented; 2.All the terms and conditions of the LC are complied with

PROCESS OF LETTER OF CREDIT

PARTIES TO AND ASSOCIATED WITH THE LETTER OF CREDIT

The various parties involved in letter of credit are:1. 2. 3. 4. 5. Applicant. Beneficiary. Issuing bank. Advising bank. Confirming bank.

Advantages & disadvantages of letter of credit

Advantages of Letter of Credit: 1. The beneficiary is assured of payment as long as it complies with the terms and conditions of the letter of credit. The letter of credit identifies which documents must be presented and the data content of those documents. The credit risk is transferred from the applicant to the issuing bank. 2. The beneficiary can enjoy the advantage of mitigating the issuing banks country risk by requiring that a bank in its own country confirm the letter of credit. That bank then takes on the country and commercial risk of the issuing bank and protects the beneficiary. 3. The beneficiary minimizes collection time as the letter of credit accelerates payment of the receivables. 4. The beneficiarys foreign exchange risk is eliminated with a letter of credit issued in the currency of the beneficiarys country.

Disadvantages of Letter of Credit. 1.Since all the parties involved in Letter of Credit deal with the documents and not with the goods, the risk of Beneficiary not shipping goods as mentioned in the LC is still persists. 2.The Letter of Credit as a payment method is costlier than other methods of payment such as Open Account or Collection 3.The Beneficiarys documents must comply with the terms and conditions of the Letter of Credit for Issuing Bank to make the payment. 4.The Beneficiary is exposed to the Commercial risk on Issuing Bank, Political risk on the Issuing Banks country and Foreign Exchange Risk in case of Usance Letter of Credits