Letters of credit can expand your business horizons

Nowadays, doing business overseas is sometimes easier than dealing with a supplier on the other side of town. Both small- and mid-sized businesses have broadened their outlook and to stay competitive that means you must do the same.

With the proper planning, a letter of credit can provide credibility for your business in markets all over the world. Of course, it also can be valuable in domestic transactions too.

A letter of credit is a legal document that a business can purchase from a bank. It guarantees payment by the bank on behalf of the business up to a certain amount. The bank usually charges the business a fee typically 1 percent or 2 percent of the total amount of the letter of credit.

Why obtain a letter of credit? A foreign supplier dealing with a small business thousands of miles away may not be willing to take a chance on receiving payment. Typically, the supplier insists on payment in advance or other guarantees, such as a letter of credit from a credible lending institution.

With a letter of credit, a small business can employ the financial clout of the bank. Presenting a letter of credit to foreign suppliers may make business transactions easier and faster because the supplier may not require payment before the goods are shipped. And the bonus to a small U.S. business is that the risk and expenses won’t be directly out-of-pocket until after it receives and inspects the goods.

There are two main types of letters of credit:

• A “trade letter of credit” is the equivalent of a check. The business pays for goods by sending the foreign supplier the trade letter of credit. The foreign supplier then goes to its bank and “cashes in” the letter of credit to receive payment.

• A “standby letter of credit.” This is really just the bank’s guarantee of payment if the business fails to do so. The bank agrees to “stand by” during the transaction as a form of insurance for the foreign supplier. If all goes well, payment is made by the purchaser and the letter of credit simply expires. The standby letter of credit may be used in major real estate transactions in this country as a guarantee of performance.

In addition to having different functions, letters of credit have other varying characteristics. For example:

• A letter of credit that requires the foreign supplier to provide certain documents (title or shipping documents, for example) before payment is made is called a “documentary letter of credit.”

• If no documents need be presented in order to receive payment, the letter of credit is referred to as a “clean” credit.

• A letter of credit addressed to a specific supplier is called a “special” letter of credit. This is the usual case. However, a letter of credit can be worded to provide payment to an entire class of people to whom the business owes money. In this case, it is referred to as a “general” letter of credit. A letter of credit (especially the general letter of credit) may also be revoked by the business purchasing it. But most letters of credit are irrevocable. nhbr

CPA Steven Feinberg, owner of Londonderry-based Appletree Business Services, is a certified public accountant with more than 15 years of experience in small-business accounting and financial management.