A letter of credit is a method of securing payment to a vendor. When a seller asks a buyer to obtain a letter of credit, it means the seller would like to ensure payment for a product he sells to that customer. Typically letters of credit are issued by a bank. The most common forms are standby letters of credit for domestic transactions and documentary letters of credit for international transactions.
Steps to Open a Letter of Credit
Establish the terms of the sale with your vendor. You will need to determine the following: How much product will you buy each month? How often will payment be due? With the answers to these questions, the amount guaranteed by the letter of credit can be determined. Typically the amount of the letter of credit will total 30 days worth of product, plus or minus 10 percent.
Do you need a documentary or standby letter of credit? A documentary letter of credit is used for international transactions and usually covers only one transaction. A standby letter of credit is a long-term contract covering a year or more.
Contact your bank to draw up the letter of credit. Once the terms of the sale have been established, your banking officer will draw up the letter. In most cases, if you hold a line of credit with the bank, the amount of the letter of credit will be held against the line of credit. If no line of credit exists, the bank may hold the amount against a money market account.
Submit the letter of credit to the buyer for approval. Often your bank will perform this step for you. The seller may ask to revise some of the wording. If this happens, your bank will need to approve the changes. Once all three parties have agreed to a final document, you may conduct business with the seller.
Ensure a documentary letter of credit is released. If business has been concluded and the vendor has been paid, the seller typically releases documentary letters of credit. This will free up your line of credit or collateral.
Ensure that a standby letter of credit is renewed. Many standby letters of credit renew automatically each year unless canceled by the bank. If an auto-renewal clause does not exist, contact your bank 60 days before the letter of credit's expiration date to avoid interrupting business.
Standby letters of credit are often required to establish a good payment pattern with a vendor. Ask your vendor annually if he can offer trade credit instead of requiring a letter of credit.