A letter of credit is used by some businesses to ensure that customers pay them for goods and services. Under a letter of credit, suppliers are paid by an issuing bank as long as certain conditions are met. Since the supplier is paid directly by the issuing bank, a company must have a line of credit or compensating bank balance in place to qualify. There are some alternatives to a letter of credit available for those companies that do not meet underwriting requirements.
Revolving Vendor Accounts
If a business does not meet bank underwriting requirements but has good history paying its vendors, it could qualify for revolving vendor accounts. If a company has a revolving account with a vendor, it can order and receive materials on credit. The goal is to collect funds from customers before the vendor payment is due. Many vendors have strict requirements that make payment on an invoice necessary from 15 to 30 days from receipt of goods. A vendor can refuse to ship any orders if a company owes it money; therefore, a company that has cash flow issues may not want to depend on revolving accounts from critical vendors. Many vendors may shy away from this type of financing arrangement, as the risk for collection falls on them.
Purchase Order Financing
Purchase order financing is a short-term credit facility where a third party assumes a company’s purchase orders. When a company receives an order, they are advanced money for purchase orders for goods to manufacture the order. Once the products ship to the customers, the finance company purchases the invoice from the company. Because a third party assumes all of the risk associated with the purchase order and invoice process, this type of financing can be very expensive. This type of financing is necessary in situations where a company has inadequate cash flow to cover the costs of manufacturing goods. The money advanced through the purchase order financing transaction is vital to the continued success of the business. This type of financing is also for businesses that do not have decent enough financing to obtain funds through a bank.
Invoice factoring is an alternative to a letter of credit. Under this type of credit facility, a third party advances a business 80 percent of invoice totals received from their customers. The third party assumes the risk of collecting the invoices. When a customer pays the invoice to the third party, a fee is withheld and the business gets the remaining balance. This is beneficial for companies suffering from a cash crunch. Like purchase order financing, invoice factoring can be quite costly, as a third party assumes all risks of collection.