Doing business overseas can be as easy as dealing with a supplier on the other side of town. Both small and mid-sized businesses have broadened their outlook by using foreign suppliers.
With the proper planning, a “letter of credit” can provide credibility for your business in markets all over the world. Of course, it can also be valuable to domestic suppliers.
How it works: A letter of credit is a legal document that a business can purchase from a bank. It guarantees payment by the bank on behalf of the business up to a certain amount. The bank usually charges the business a fee—generally, 1% or 2% of the total amount of the letter of credit.
Why would a business incur this cost? A foreign supplier dealing with a small business thousands of miles away may not be willing to take a chance on receiving payment. Typically, the supplier insists on payment in advance or other guarantees.
Instead, with a letter of credit, a small business can utilize the financial clout of the bank. The foreign supplier knows that the bank will be there to make payment. Result: The supplier may not require payment before the goods are shipped. And the small U.S. business knows that it will not be out-of-pocket until it receives and inspects the goods.
There are two main types of letters of credit:
A “Trade Letter of Credit” is the equivalent of a check. The business pays for goods by sending the foreign supplier the Trade Letter of Credit. The foreign supplier then goes to the bank and “cashes in” the letter of credit to receive payment.
Another type of letter of credit is the “Standby Letter of Credit.” This letter of credit is really just the bank’s guarantee of payment if the business fails to do so. The bank agrees to “stand by” during the transaction as a form of insurance for the foreign supplier. If all goes well, the letter of credit simply expires.
The Standby Letter of Credit may be used in major real estate transactions in this country as a guarantee of payment.
In addition to having different functions, letters of credit have other varying characteristics. It is important for business owners and managers to understand the terminology. For example:
A letter of credit that requires the foreign supplier to provide certain documents (e.g., title or shipping documents) before payment is made is called a “Documentary Letter of Credit.”
If no documents need be presented in order to receive payment, the letter of credit is referred to as a “clean” credit.
A letter of credit addressed to a specific supplier is called a “special” letter of credit. This is the usual case.
However, a letter of credit can be worded to provide payment to an entire class of people to whom the business owes money. In this case, it is referred to as a “general” letter of credit. A letter of credit (especially the general letter of credit) may also be revoked by the business purchasing it. But most letters of credit are irrevocable.
Michael Mountjoy is a CPA/ABV with Mountjoy & Bressler, LLP. He may be contacted for more information at 502-992-2700 or mmountjoy@mountjoybressler.com.
