Import and Export Letter of Credit

A letter of credit is a vital tool for facilitating international trade. It benefits both the importers and exporters. An import letter of credit enhances the credit worthiness of the importer while an export letter of credit mitigates the credit risk for the exporter and helps improve his cash flow.

Import Letter of Credit

Import letter of credit is issued by the importer’s bank on behalf of the importer with the exporter being the beneficiary. It is a guaranteed by the importer’s or buyer’s bank that the payment will be given to the exporter or seller. The credit capacity of the importer is substituted by the credit capacity of the issuing bank. This improves credibility and reduces the risk of fraud. There are terms and conditions regarding the type, quantity, place of delivery and time of delivery mentioned in the import letter of credit. It also mentions the documents to be submitted as proof of shipment. The exporter has to submit some specified documents fulfilling these conditions before the payment can be released to him.

Advantages of Import Letter of Credit

The biggest advantage of import letter of credit is fraud risk mitigation. The exporter has to submit valid documents as proof of shipment of agreed upon goods before the payment can be made. The terms and conditions under import letter of credit cannot be changed unless all the parties agree, so it’s legally binding. An import letter of credit increases the credit-worthiness of the importer because credit capacity is transferred to the issuing bank. This enables importer to get a better bargain on the prices of imported goods and also access extra funding for expanding his business. Since an import letter of credit is of immense help in less established trade relationships, it provides a safe way to expand sourcing into new geographies for getting lower prices and hence increasing importer’s business margins.

Disadvantages of Import Letter of Credit

The issuing bank is required to pay the exporter as and when he presents the documents covered in terms and conditions of the import letter of credit. There is a risk of receiving bad or damaged goods even if the documents are satisfactory. An importer can mitigate this risk by verifying the exporter’s reputation and checking a sample of goods beforehand. He can also hire an independent third party to do the physical inspection of goods before they are shipped. Issuing a letter of credit adds to the cost of doing business.

Export Letter of Credit

An importer issues an import letter of credit with the exporter being the beneficiary. The same letter of credit, when received by the exporter’s bank, becomes an export letter of credit. So, both the import and export letters of credit are materially same, it’s just the perspective which is different. The exporter needs to fulfil the terms and conditions and submit the required documents as mentioned in the letter of credit before he can receive payment.

Advantages of Export Letter of Credit

It reduces the credit risk as the issuing bank is liable to pay even if the importer defaults. Export letter of credit can be tailored to the needs of the exporter, hence it provides flexibility in terms and conditions as long as they are fair and legally binding. Since the exporter needs to submit documents as proof, an export letter of credit enables the exporter to receive the payment before the shipment has reached the importer. This capability improves the cash flow of the exporter.

Disadvantages of Export Letter of Credit

Although the exporter is protected in case the importer defaults on payment, he may still face credit risk if the issuing bank also defaults. He can get additional protection by getting a confirmed letter of credit where the receiving bank guarantees the payment if issuing bank defaults. This will add to the cost of getting a letter of credit, which is already high.

Export Credit Insurance vs Letter of Credit

Export credit insurance is taken by an exporter to insure the foreign accounts receivables in a case of commercial and political risks. The exporter has to pay a premium to get insurance cover. This is different from a letter of credit where the importer has to cover most of the expenses. A letter of credit has strict terms and conditions regarding the goods shipped and documents to be presented before the payment is made. Export credit insurance just needs a proof of non-payment of accounts receivables by the foreign party. A letter of credit covers 100% of the amount while export credit insurance works on risk sharing and covers only a part of the amount (usually up to 90%).



Last updated on : July 12th, 2017
What’s your view on this? Share it in comments below.

Leave a Reply

Mortgaged Debentures
  • Clean Bill of Lading
    Clean Bill of Lading
  • Term Loan or Project Finance – A Long Term Source of Finance
    Term Loan or Project Finance – A …
  • Asset Financing
  • Venture Funding
    Venture Funding
  • Subscribe to Blog via Email

    Enter your email address to subscribe to this blog and receive notifications of new posts by email.

    Join 122 other subscribers

    Recent Posts

    Find us on Facebook

    Related pages

    what is abc analysis in inventory management with exampleinterpretation of irrlc margin moneyworking capital financing pptsupernormal growth calculatorrental meaning in hindiaverage collection period calculatorfixed assets turnover ratio calculatordiscounted cash flow model examplehow to calculate tie ratiowealth maximisationstakeholders and stockholdersirredeemable preference sharesinvoice receivablescompounding technique of time value of moneysharemarketschooldcf calculation formulamanagerial accounting versus financial accountingarbitrage pricing modelwealth maximization objectivewhat is meant by debit and credit in accountingarbitrage portfolionon convertible debenturesaccounts payable period formulahow to calculate sales turnover ratiomeaning of bookkeepingirr disadvantagesmarginal cost pricing formulacalculating payout ratiodual aspect concept of accounting with exampleshow to calculate market value of equity from balance sheetfactored debtswhat is operating cycle in accountingfinancial leverage calculation formulawhat does lc at sight meanadvantages and disadvantages of invoice discountingequation for inventory turnoverdisadvantages of paybackdebentures meanstimes interest earned ratio analysisdiscounted cash flow valuation exampleshareholder equity definitionwhat is the meaning of debitedmeaning of instalmentnpv opportunity costincremental budgeting definitionacid quick ratiousance period in letter of creditinternal rate of return definition simplepurpose of profitability ratiosthree stage dividend discount modelaccounting knowledge in hindiinventory turnover meaningcalculating degree of operating leveragepost finance efinanceincremental versus differentialhow to find gross margin ratioeoq inventory modelmodigliani miller approach of capital structureliquidating companyexplain overdraftleasor vs leaseeaccounting definition of debitdifference between fund flow and cash flow statementreasons for merging companiesinstalment buying definitionexamples of capital employedcost of debenture formuladiscounted cash flow equationinterpreting accounting ratiosirr and mirrwacc and cost of equitymarginal cost of capital calculatoroperating lease and capital leasevalue maximization stakeholder theory