Letter of Credit
What is a Letter of Credit You may have heard of the term “letter of credit,” but you don't know what it is. When starting up a business, or just with small businesses in general, letters of credit can be very useful. Let's say that you own a pink stuffed dinosaur distribution company. A very good customer provides you with a very large purchase order for pink stuffed dinosaurs. Since you distribute (rather than manufacture) pink stuffed dinosaurs, you'll need to place an order with your pink stuffed dinosaur supplier in order to be able to fulfill the order. Since it is such a big order, in this case, you want to use a new pink stuffed dinosaur supplier that is located in Australia and does not know much about your company. Your Australian supplier is most likely going to ask for cash up front or some guaranteed form of payment before manufacturing and delivering the pink stuffed dinosaurs. You, on the other hand, will want to pay upon receipt, or better yet, ask for 30-day payment terms (meaning, you pay 30 days after receipt). To solve this situation you can go to the bank and ask them to create a letter of credit for this transaction. The letter of credit stipulates that your supplier will be paid by the bank, if they comply with the terms of the L/C. Usually, to comply with a letter of credit, documentary evidence that proves delivery of a quality product per the agreement needs to be provided. Now your supplier can go ahead and deliver the pink stuffed dinosaurs, knowing that he will be paid if he delivers according to the agreement. As you can see, this protects your supplier, and the letter of credit also protects you, because it ensures that the supplier is paid only if he complies with the agreement. Although letters of credit come in a number of flavors, in general they tend to guarantee payment by the issuing bank, which gives suppliers a level of comfort. Of course, once funds are paid to your supplier you will need to pay the bank. Usually, banks will ask that you have a line of credit (or similar financing) so that they can satisfy payment for the LC from that account. Unfortunately, this also means that to qualify for a letter of credit you almost always need to qualify for traditional bank financing. This is not easy for new, small or growing businesses. If you cannot qualify for a letter of credit, your best alternative is to secure trade financing use purchase order financing.
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