It's increasingly common today to buy from and sell to people in other states and even all over the world. At least at first, you don’t know whether you can trust each other to pay for or deliver the products. Banks serve as intermediaries by providing documents to assure that suppliers will be paid and jobs will be completed as stated. It’s important to know the difference between a bank guarantee and letter of credit as well as when a standby letter of credit might be used.
Explaining LCs and Their Purpose
Letters of credit (LCs) are used most often in international business deals when the buyer and seller do not know each other or know of each other's reputation. They may also be used in domestic deals that are large and therefore carry more risk. Generally speaking, the larger the deal's risk, the more likely it is for one party to request an LC.
Essentially, the bank assumes the risk by issuing credit to the buyer and promising the seller that he will get paid. If the buyer doesn’t pay on time, the bank pays the invoice and then works with the buyer to be repaid. LCs are short-term financial tools that usually expire in 90 days.
In addition to providing payment if needed, LCs are beneficial to have because they require that the items purchased and the terms of the sale are described in detail. This makes it easier to determine that the products delivered are exactly as described in the LC.
Differentiating an SBLC
An LC is a straightforward document that doesn't contain added clauses or terms. If the buyer is requesting more complicated or varied products or those that will be delivered throughout the year, she may be asked to get a standby letter of credit (SBLC) from her bank. For example, say a buyer wants to purchase 30,000 sweaters of various colors and designs to be delivered in shipments throughout the year with a maximum of 1% having imperfections.
SBLCs are longer-term financial tools that may be in effect for a year or more. For this reason, they are often used in large construction projects, such as major infrastructure changes or refurbishment. The bank often asks for collateral to be put against the SBLC — either cash or an asset that can be sold quickly to pay back the bank if the SBLC is used.
Since SBLCs are used in bigger deals, greater risk is involved in trusting the other party. An SBLC is like an insurance policy that is only given to companies that are extremely credit worthy and most likely won't need to use the SBLC. Therefore, getting one requires more underwriting, such as looking at the company's credit history, cash on hand and the outcomes of previous deals. When you have an SBLC, it tells other companies that your company is a good credit risk and can be trusted.
Defining Bank Guarantee
A bank guarantee (BG) is also used in large commercial real estate builds and infrastructure deals. A company that's bidding on a big deal may include a BG with its bid to demonstrate its solid financial background and trustworthiness, hoping that this will help get the job.
If the business that's hiring the contractors is concerned about a specific aspect of the deal, it may ask for a particular type of BG. For example, a performance BG ensures that the exact specifications of the contract will be met, while a loan guarantee assures that the bank will take on the debt owed if the company defaults.
Comparing SBLC vs. BG
While the difference between a bank guarantee and letter of credit is readily apparent – an LC is a rather simple, straightforward document, while a BG is used in big construction deals — comparing SBLC vs. BG is more involved. The major differences between SBLC and BG are:
- Purpose: BGs are used more often than SBLCs in large construction deals, while SBLCs are used more often in the sale of goods.
- Function: BGs can protect both sides of a deal, while SBLCs cover only the company that obtains the SBLC.
- Cost: BGs cost more to obtain because they protect both sides of the deal.
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