Whilst a letter of credit is an excellent tool in terms of providing payment security to the seller and more certainty of shipment of the goods / provision of services to the buyer, it can also be very useful for improving cash flow for both parties. This factor is rarely considered by sales or purchasing managers when negotiating contracts with overseas trading partners.
It is quite common for export sales or finance managers to turn away potentially lucrative contracts due to the buyer requesting unacceptable credit terms, often well in excess of the seller’s normal terms of payment.
There is however, absolutely no reason why a seller should not accept such terms provided that the letter of credit gives the appropriate level of security.
If the credit is available with an approved nominated bank in the seller’s country and such bank has given a clear commitment or a confirmation to the seller, it is possible to receive funds immediately following presentation of complying documents, ie: at ‘sight’, even though the credit may be available by acceptance or deferred payment (eg: 90, 120, 180 days etc).
Under such terms, the nominated bank may be prepared to prepay the seller by way of ‘discounting’ the draft (bill of exchange) presented with the documents, or to ‘negotiate’ the documents, either with or without recourse to the seller, deducting interest for the duration of the credit period.
In the case of confirmed letters of credit, such discounting or negotiation will usually be made without recourse, thus providing the seller with financing that is normally viewed as ‘off-balance sheet’.
By engaging with the nominated bank at the earliest opportunity, sellers can establish the cost of financing (often at lower rates than borrowing on overdraft for the period), and factor into the price.
Buyers can use letters of credit as a means of obtaining longer periods of credit in the knowledge that the supplier can still obtain payment at an early stage. In the Far East and Asia, it is common for suppliers to view letters of credit issued by major banks as a tool for obtaining pre-shipment finance. We have come across many instances where UK or European buyers have been able to obtain significant discounts on the price of goods purchased, by issuing letters of credit instead of trading on open account terms.
You may find our other articles on the subject of financing useful: