Last editedJan 20222 min read
Managing cash flow is a key consideration for all SMEs. When accounting for payments made and received, businesses need as much certainty and assurance as possible. Especially when they trade in high-value items or services. All it takes is for a payment to go awry and it can leave your business financially vulnerable.
As such, many businesses use a letter of credit to mitigate the risk associated with high-value transactions or transactions that involve other forms of risk such as shipping goods overseas. However, there are costs associated with this, which need to be taken into account for cash flow projections. Here, we’ll look at the functions and costs associated with letters of credit.
What is a letter of credit?
A letter of credit is a document from a bank that guarantees payment for goods or services. It provides protection for both the seller and the buyer.
Businesses can apply to their bank for a letter of credit, and the bank will determine whether or not to approve based on whether sufficient assets (or credit) are available.
How does a letter of credit work?
A letter of credit is a type of negotiable instrument. The issuing bank commits to pay the beneficiary or any bank nominated by them. If the buyer fails to make payment to the seller, a letter of credit provides a legal obligation to make payment as long as the seller has met all the conditions laid out in the letter.
However, they also protect buyers by ensuring that they’re not left out of pocket if a seller is not able to deliver on the goods and services that they promised.
Types of letter of credit
There are several different types of letter of credit, each designed to prevent missed payments in different transactional contexts. They are as follows:
Commercial letter of credit – The bank makes direct payment to the beneficiary (seller) on the buyer’s behalf
Standby letter of credit – The bank makes payment to the beneficiary (in this case the buyer) if the holder (seller) cannot
Confirmed letter of credit – A confirmed letter of credit is guaranteed by a bank other than the issuing bank. In most cases this is the seller’s bank
Revolving letter of credit – A customer is allowed to make an allotted number of withdrawals within an agreed time limit.
What is the average cost of a letter of credit?
Letters of credit incur charges from the banks that issue them. These need to be factored into cash flow projections and weighed against the level of assurance that they bring to a transaction.
Some fees are borne by sellers, while others are assumed by buyers. There is no agreed standard or amount for letter of credit fees, but most charge a percentage of the value of the transaction. This is in order to mitigate the bank’s own risk in guaranteeing payment.
A buyer will typically pay anywhere between 0.75% and 1.5% of the transaction’s value, depending on the locations of the issuing banks. Sellers may find that their fees are structured slightly differently. Instead, they may pay a set of small flat fees that vary in cost.
What do the fees cover?
There are a number of administrative processes that go into verifying a letter of credit, and the fees go towards covering these. These include bank-to-bank reimbursement fees, as well as charges for postage and courier services.
We can help
If you’re interested in finding out more about letters of credit and their associated costs, then get in touch with our financial experts. Discover how GoCardless can help you with ad hoc payments or recurring payments.