Letters of credit and letters of guarantee, also known as bank guarantees, are financial tools that create cash flow for small businesses. LCs and LGs are credit lines that guarantee payments for goods and services. They're commonly used in international trade between sellers and buyers who lack established business ties or are unfamiliar with each other's trade laws or customs. Letters of credit facilitate transactions by releasing funds when all sales-agreement terms are met. Letters of guarantee help to protect buyers and sellers from losses, much like insurance policies.
Companies looking to buy goods or services apply for letters of credit through their banks. When a buyer and seller work out and confirm all the terms of a sales agreement, the bank transfers the funds to the seller's bank account. Sellers are called the "beneficiaries" of credit lines. The buyer and seller might agree, for example, that a textile shipment is to be delivered to a dry goods shop by the first of each month. The letter of credit guarantees that the seller receives payment by a certain date in an agreed-upon amount when the seller delivers the goods or services. If the buyer can't make a payment, the bank must pay either the full amount or the balance of the purchase.
Letters of guarantee protect buyers and sellers from damages or losses in sales agreements. Qualified buyers apply for LG funds from their banks, just as they would apply for lines of credit. Letters of guarantee allow small businesses to improve cash flow and expand into global markets as importers or exporters without suffering losses. Once buyers are approved for LGs, the funds are guaranteed. However, sellers are paid only when one of the two parties fails to honor the sales agreement. When the buyer, as the LG holder, can't pay the seller, the bank covers the debt.
Application forms for letters of credit and letters of guarantee vary by bank, but generally include basic information. Applicants for letters of credit fill in data such as the name of the bank's branch, the application date, the expiration date, and the applicant and beneficiary's name. Applicants also might specify how the bank should issue the LC funds to the beneficiary's bank, usually by mail or electronically; the currency and payment amount; and whether partial shipment of the goods is acceptable.
Application forms for letters of guarantee require the applicant and beneficiary's names; they might also include space for details of any conditions or obligations on the applicant or beneficiary's part.
Some letters of credit are transferable, which means the LC holder's bank may pass on payment to a third party, such as a manufacturer or wholesaler. Revolving letters of credit are used for sales agreements in which the buyer is to receive regular shipments over a period of time. In this case, the letter of credit holder's bank reissues the credit line as funds are drawn on the account. Banks issue confirmed letters of credit when sellers, or exporters, are concerned about the credibility of the buyer's bank or native country. Sellers may look for a second bank, typically from their native country, to grant a confirmed LC to cover payment. Standby letters of credit are similar to letters of guarantee in that they pay for sellers' goods when buyers default on sales agreements.
A payment guarantee protects suppliers if buyers fail to pay on time. Banks issue performance bonds as guarantee payments of a certain amount when sellers breach the agreements made with buyers. Letters of guarantee also are issued for advanced payments, customs guarantees and credit collateral.