Letter of Credit Example - How Money and Documents Move
A letter of credit (LOC) is a promise from a bank to make a payment assuming certain conditions are met.
LOCs are complicated. The easiest way to understand how they work is to see an example. This tutorial shows how a letter of credit works step-by-step. You can also just read an overview if you prefer a text-only explanation without the visuals.
For this example, we’ll assume that an importer is buying goods from an exporter. However, LOCs can be used for other types of transactions. Standby letters of credit, for example, are regularly used within the United States for a variety of services (including building projects, electrical service, and more). If you want to learn how a LOC works for a common domestic transaction, replace the terms “importer” and “exporter" with a customer or service provider in your industry. For example:
- The exporter could be an electric utility company that sells power; the importer would be a customer that buys power from the utility
- The exporter could be a contractor that promises to complete a project by a certain date; the importer would be the contractor’s customer
Note that this tutorial shows how the concept works, but a real transaction is much more complex than what you’ll see here. For now, the idea is just to get comfortable with the flow of documents and payments when a LOC is used.
Let's Do This!
First, a buyer (importer) and seller (exporter) decide to do business together. They agree on a price, quantity, and other terms, and they specify how and when the goods will be shipped to the buyer. As part of the agreement, we’ll assume that the seller wants the buyer to use a letter of credit (LOC).
Why does the seller demand a letter of credit? The seller wants more confidence that the buyer will pay. Perhaps this buyer and seller have never worked together, or the order might be large enough to cause severe financial hardship if something goes wrong (if the seller spends money to produce and ship goods, and the buyer’s assets are seized for some reason).
It’s important to know that the sales agreement is not part of the letter of credit. The sales agreement is between the buyer and the seller only, and the LOC uses information in the agreement, but the LOC is a separate document issued by a bank.
Issuing the LOC
To get a letter of credit (LOC), the buyer contacts her bank. That bank operates in the buyer’s home country, and is most likely a bank that the buyer currently does business with. The buyer provides information that is needed for the bank to issue the LOC, including details like:
- How much is the payment?
- What is the name and address of the seller (known as the beneficiary)?
- When will it be shipped?
- How will it be shipped?
- Where should the shipment arrive?
- And numerous other details
It’s essential that the bank gets all of the details correct. The LOC will be a legally binding document, and these documents are interpreted literally. Again, the LOC is separate from the sales agreement, and it’s based on documents – not actions – so you can't assume that everything will work out if there’s an error (even a seemingly minor item like a typographical error); if the document isn’t perfect, it needs to be redone before anybody moves forward.
When the bank issues the LOC, the bank will have made a promise, and the bank will be responsible for sending money (that’s what makes a letter of credit so safe for sellers) – so the bank wants to know that the buyer can actually come up with the money. At this point, the buyer may have to deposit funds with the bank, or the bank might offer a loan to the buyer as part of the LOC.
After issuing the LOC, the bank sends it to the seller’s bank. This is typically a bank in the seller’s country – presumably a bank that the seller already has a relationship with. There may be several banks in between acting as intermediaries, but we’ve left them out for simplicity.
The seller’s bank will review the LOC and forward it to the seller. At this point, the seller should review the LOC to ensure that it matches what she agreed to do and that she is capable of meeting the requirements of the LOC. She should also decide if she is comfortable trusting the issuing bank and any other banks involved.
If everything is acceptable, the seller can move to the next step: produce and ship goods.
Sending Goods and Documents
To get paid with a letter of credit (LOC), the seller will need to meet the requirements specified in the LOC. Among other things, that generally means:
- Shipping the goods by a certain date
- Possibly having the goods inspected before shipment
- Using the shipping method specified in the LOC
- Shipping to and from ports specified in the LOC
- Gathering documents specified in the LOC (shipping documents, for example)
- Submitting documents to the bank by a certain date
This is where sellers really enjoy the benefits of a letter of credit. The seller knows that she will get paid (assuming the bank that promised payment is good for the money) as long as she meets the requirements of the LOC. It doesn’t matter if her customer has gone bankrupt or decides not to pay – the bank is on the hook for payment; the bank will have to deal with the end customer.
Likewise, depending on how things were arranged, it doesn’t even matter if the goods ever make it to the customer. A storm may damage or destroy the goods during shipment, and the seller might not be responsible for that loss.
The main challenge for the seller is meeting the requirements of the LOC. Again, banks only care about the details written into the LOC and the documents you submit to satisfy the LOC. If anything is off, the seller won’t get paid.
For example, if you ship one day late, it’s a major problem. You might throw in some extra product for free (and your customer might even agree that this makes up for the late shipment), but banks won’t pay unless the LOC is amended to account for the later shipping date. It takes extra money and time to amend a LOC.
Payment and Shipment Arrive
Once documents are submitted to the seller’s bank, the bank will verify that the documents meet the requirements of the LOC. Again, the bank will take everything literally: if anything is off – even the spelling or abbreviation of a company name – the bank can refuse payment. Banks take several business days to conduct this review.
If the documents are good, the seller’s bank will forward the documents to the buyer’s bank. The buyer’s bank will perform the same review of documents against the LOC. If everything checks out, the buyer’s bank will send payment to the seller’s bank.
The buyer’s bank will then forward the documents to the buyer, who uses those documents to take possession of the goods when they arrive.
When does the seller get paid? The timing of payment depends on the type of LOC used. The seller might get paid within a few days of submitting documents to a local bank. In other cases, the seller will have to wait until certain conditions are met. Sometimes the seller gets paid an “advance” (before shipping anything) so she can buy resources that will be used to produce the customer’s goods.