Letters of Credit (L/C) and Trust Receipts (TR) are commonly used to improve cash flow for any type of business that imports or exports goods for sale or supplies commodities for use in the production of finished goods.
Whether starting your own business or expanding an existing business L/Cs and TRs are important financial instruments designed to reduce risk and trim the high cost of potential import/export trade operation failures.
Successful import/export cash flow scenarios rely on these types of financial strategies to create operational efficiencies important to thwarting risks associated with a buyers receipt of contracted goods and a sellers receipt of payment for such goods.
The Letter of Credit
A Letter of Credit or L/C is a document issued by a bank to guarantee payment to a seller for a specified amount, at a certain period of time. The buyer gains protection through absolute compliance to the L/C terms before the payment to the seller is released.
The Trust Receipt
A Trust Receipt or TR is a document of release of goods to a customer by a bank. After an L/C is drafted and the import shipment has arrived, this type of additional financing may be offered in place of a buyers immediate payment. The customer may use or sell the goods but the bank retains title to them.
Function of Credit Instruments
A typical scenario where an L/C is used is when an importer applies to a bank for credit to pay an exporter. When the buyer receives the goods from the seller and is deemed compliant with the L/C in terms of timely presentation of documents and goods that conform to the conditions set out by the L/C, the funds are released from the bank to pay the seller.
Commonly, if the importer is in good standing with the bank, an offer of TR financing will be extend. When the terms of the TR are agreed to (usually for payment in 60 to 90 days at a specified rate), the bank will release the goods to the buyer for the purpose of manufacture or sale whilst retaining the the title to the goods. The buyer is required to keep the goods separate from its other business and hold the goods or proceeds from the sale of goods subject to remittance or repossession of the bank.
Advantages of Credit Instruments
Major advantages of using a L/C for import/export transactions include the buyer's ability to access certain suppliers who will not trade without a letter of credit, payment of receivables is accelerated and supplier collection time is reduced. In these cases, the buyer is assured payment as long as the L/C is compliant to its terms.
When you use a TR, the buyer need not make payment immediately when documents are presented. Among other advantages, the importer may take possession of the goods for resale before paying the bank. As well, the buyer's working capital or cash flow is not tied up and can be used for other business purposes.
Considerations when using Credit Instruments
L/C financing may help with cash flow but the fees associated with documentation and loan rates can be cost prohibitive. As with any contract agreement, reviewing the details of the L/C before signing is of utmost importance.
Buyers may gain major advantages if the supplier does not participate in forming the terms of the L/C. The seller should always review the contract in its early stages to resolve discrepancies and vet errors before any bank is involved. If an error needs to be corrected or terms adjusted, banks will charge additional fees. Sellers can request that buyers pay for all bank fees associated with the L/C.
TRs may have unattractive associated rates and fees that can outweigh the advantages of convenience and freed-up working capital. Other instruments like Import Documentary Collections may better help to reduce costs.