Here Are The Unknown Advantages And Advantages Of Online Business – LC is a complex product for new importers and exporters. It is ideal to check the pros and cons of a letter of credit (LC) before choosing it. The letter of credit is highly adaptable and enables the establishment of new trade relations, reducing credit risk, but may increase business costs in the form of bank fees and formalities. Let’s take a closer look at the pros and cons of credentials:
Letter of credit has various advantages in international trade transactions. Here are some of the main ones:
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A letter of credit gives trade partners the opportunity to do business with unknown partners or in newly established trade relations. It helps to quickly expand the business to new geographical locations.
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A letter of credit is highly customizable. Both trading partners can set conditions according to their requirements and arrive at a common list of clauses. It can also be adjusted from one transaction to another with the same trading partners.
The letter of credit makes the issuing bank independent of the obligations of trading partners and all disputes arising from these obligations. The bank must check whether the documents submitted by the user comply with the terms of the letter of credit and pay the full amount.
The letter of credit transfers creditworthiness from the importer or buyer to the issuing bank. An importer can perform multiple transactions at the same time if he has an established and larger institution such as a bank.
A letter of credit is safer for the seller or exporter in case the buyer or importer goes bankrupt. Since the creditworthiness of the importer is transferred to the issuing bank, the bank is obliged to pay the amount specified in the letter of credit. Therefore, the letter of credit insulates the exporter from the business risks of the importer.
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A letter of credit can be drawn up quickly. In accordance with the original terms and conditions, the seller or exporter must provide proof of the type and quantity of materials and shipping documents to support their claim that the goods have been shipped. The advising bank will check the documents and make the full payment.
In the event of a dispute between trading partners, the exporter can withdraw the funds in accordance with the letter of credit agreement and later settle the dispute in court. The beneficiary’s right to the full amount is described in the phrase “pay now, litigate later”.
The importer cannot withhold or refuse payment to the exporter, expressing objections to the quality of the goods, because the bank needs to see documents that comply with the terms and conditions of delivery specified in the letter of credit.
A letter of credit provides clarity on the amount and timing of the exporter’s cash flows. He can plan his financing needs in time, which reduces his risk.
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The exporter can use pre-shipment financing against the letter of credit. This helps him to address funding gaps, if any.
A letter of credit increases the cost of doing business. Banks charge a fee for providing this service, and it can rise sharply if the parties want to introduce some additional features.
The required documentation and formalities may be more in the letter of credit. It can also increase the cost of doing business.
A letter of credit has complex regulatory rules and some notorious buyers or sellers can abuse it to take advantage of it.
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A letter of credit represents a significant risk of fraud for the importer. The bank will pay the exporter based on the shipping documents and not the actual quality of the goods. Disputes may arise if the quality differs from the agreement.
A letter of credit also involves currency risk. The letter of credit will contain the agreed currency. At least one of the parties will have a currency different from this and will therefore face risk due to currency fluctuations. It can also work for good.
The letter of credit has a validity period, and therefore the exporter has a fixed deadline in which he must deliver the goods. Sometimes this rush creates chaos.
A letter of credit essentially transfers creditworthiness from the importer to the issuing bank. Therefore, if the issuing bank defaults, the exporter still faces payment risk. Although the exporter can avoid this, having the advising bank’s guarantee for payment will increase the cost of the letter of credit.
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Sanjai Borad is the founder and CEO of the company. He is passionate about keeping things simple and easy. I have been running this blog since 2009 and I try to explain “Financial Management Concepts in Layman’s Terms”.
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