A letter of credit, also known as LC, is a document issued by a bank or financial institution. The primary purpose of the letter of credit is to ensure the timely payment to the seller on behalf of the buyer for a business transaction. It provides a safety net for sellers, ensuring they receive payment for goods and services.

If, for any reason, the buyer is unable to make payment, the bank will cover the complete or remaining amount on behalf of the buyer. The letter of credit document is issued against a pledge of cash or securities. For issuing the document, banks collect a fee, which is typically a percentage of the amount or size of the letter of credit.

The letter of credit is classified into different types based on the business usage and requirements.

Commercial Letter of Credit

In this type of letter of credit, the issuing bank makes a direct payment to the beneficiary once all terms and conditions are met.

Standby Letter of Credit

A standby letter of credit is also a secondary payment method. The bank pays only if the buyer defaults on the agreement.

Revolving Letter of Credit

It is a type of letter of credit that allows for multiple withdrawals over a specified period, up to a total limit.

Traveller’s Letter of Credit

It is a type of credit issued to travellers, allowing them to withdraw money from foreign banks during travel.

Confirmed Letter of Credit

It is a type of letter of credit in which a second bank, typically located in the beneficiary’s country, guarantees payment, in addition to the issuing bank, providing enhanced security to the seller.

Sight Letter of Credit

In this type of letter of credit, payment is to be made immediately upon presentation and verification of the required documents.

Acceptance or Timed Letter of Credit

It is a type of letter of credit that allows payment to be made at a future date, typically after a specified credit period, once the documents have been accepted.

Revocable Letter of Credit

It is a type of letter of credit that can be amended or cancelled by the issuing bank at any time without the beneficiary's consent.

Irrevocable Letter of Credit

It is a type of letter of credit that cannot be amended or cancelled without the agreement of all parties involved, offering greater protection to the beneficiary.

Back to Back Letter of Credit

In this type of letter of credit, sellers use an LC received from a buyer to open a second LC in favour of their supplier, commonly used in intermediary trade.

Transferable Letter of Credit

It allows the original beneficiary to transfer all or part of the credit to another party, typically used when intermediaries are involved.

Restricted Letter of Credit

This type of letter of credit specifies a particular bank that is authorised to pay, accept, or negotiate the credit, limiting the choice of handling the bank.

Every kind of letter of credit is written in an official document and agreed upon by both parties. Here is a step-by-step procedure on how the letter of credit process works.

Step 1: Issuance of Letter of Credit

Once the parties involved agree to the sales contract, the buyer or importer applies for a letter of credit in favour of the exporter to the issuing bank.

The issuing bank sends the prepared letter of credit to the advising bank. The advising bank then verifies the authenticity of the letter and then forwards it to the exporter.

Step 2: Shipping of Goods

After acquiring the letter of credit from the advising bank, the exporter initiates the export and shipping logistics process.

Step 3: Providing Documents to Confirming Bank

Once the goods are shipped, the exporter then presents the letter of credit to the confirming or advising bank.

Step 4: Settlement of Payment from Importer

The exporter’s bank then sends the document to the issuing bank, which then verifies every document and then receives payment from the importer.

The document is then sent to the importer. The importer further uses it to get possession of the shipped goods.

Obtaining a letter of credit is crucial for business. Here are some of the benefits of a letter of credit.

Lowers the Risk of Non-paying Importers

One of the benefits of the letter of credit is reducing the risk of non-paying importers. It ensures that the exporter will get their payment as long as their conditions are met.

The document ensures that the exporter receives payment in situations where the importer refuses to pay or goes bankrupt.

Helps Exporter Manages the Cash Flow

Another crucial benefit of the letter of credit is better cash flow. With the letter of credit, exporters are guaranteed payment, especially when there is a gap between the delivery of goods and payment.

Establish Reliability and Trust

A letter of credit demonstrates financial credibility and commitment between buyer and seller. It fosters trust, especially in international trade, where parties may be unfamiliar with one another.

Tailored to Business Needs

A letter of credit can be customised to suit the specific requirements of a business transaction. Different types of letters of credit address various risks, timelines and trading arrangements.

Along with all the above-mentioned benefits, a letter of credit comes with some limitations, too. Here are some of them:

• The letter of credit imposes fees on the buyers.
• A credit does not address all transactional aspects, such as product quality or delivery speed.
• The letter of credit also fails to accommodate unforeseen situations, such as political instability and supply chain disruptions.
• The letter of credit process is time-consuming for both parties.
• The entire process of a letter of credit depends on the efficiency and reliability of banking institutions.

To understand the letter of credit in detail, consider the example of an ABC importer in the USA who wants to purchase electronic goods from the XYZ manufacturer in India. To ensure a smooth transaction, XYZ's manufacturer requested a letter of credit from the ABC importer’s bank.

The document has been issued by the bank in favour of the manufacturer, ensuring payment upon presentation of shipping documents and invoices.

Once the goods have been shipped and the documents are submitted to the bank, the bank will release the payment to the manufacturer.

This entire letter of credit process secures the payment of both parties, ensuring that the manufacturer receives payment and the importer receives the goods in exchange.

To obtain a letter of credit from the bank, the proper documents must be submitted. These documents include:

• Bill of lading
• Application form with photograph and address
• Bill of exchange
• KYC of applicant
• Certificate of origin
• Shipping, packing and transport documents
• Certificate of inspection
• Commercial invoice
• Insurance certificate
• Additional documents required by lender

Like any other official document, the letter of credit document is drafted and prepared by the bank officials. Here are some of the key details mentioned in the letter of credit document.

• Current date
• Name and address of the exporter or beneficiary
• Amount to be credited
• Expiration date
• Letter of credit number
• Beneficiary bank details
• Terms and conditions of the document
• Sign of the bank's official

Multiple parties are involved in the letter of credit process. These parties are:

Applicant

An applicant is the party that requests a letter of credit from a bank or financial institution. This is generally the importer.

**Beneficiary **

A beneficiary is the party that receives the payment under the letter of credit process.

Issuing Bank

The bank or financial institution that issues and reviews the letter of credit. This bank also holds onto the funds involved in the transaction.

Negotiating Bank

It is the bank that negotiates the letter of credit document submitted by the exporter. The negotiating bank can be either an advising bank or a separate bank.

Advising Bank

This is the bank that generally acts on behalf of exporters, as it is located in the country of the exporter. This bank generally receives the letter of credit from the issuing bank. It is also responsible for transferring the documents to the issuing bank.

Conforming Bank

This is the bank that offers the additional guarantee to the issuing bank. However, this bank only comes into the picture if the exporter is not satisfied or has doubts about the issuing bank.

Intermediary

The intermediary is the third party involved in the process that helps beneficiaries and applicants with the letter of credit details.

Also Read: What is Bill of Entry: Guide to its types, importance, and Process

Understanding the letter of credit is crucial for businesses involved in import and export activities. This official document helps ensure that the exporter receives payment and the importer receives the goods. With the various letters of credit and types, import and export businesses can secure themselves from unfortunate financial losses.

Along with getting letters of credit, businesses should also invest in marine Insurance plans. Marine insurance in India offers protection to businesses against the loss or damage of goods in transit, whether by land, air or sea. With marine cargo insurance, companies can safeguard their shipments against risks such as theft, accidents, natural disasters and more.

TATA AIG offers a suite of SME insurance plans for businesses in India. Companies can buy business insurance online with TATA AIG and protect their businesses against the financial losses of several incidents like fire, burglary, theft and more.