Dealing with overseas suppliers is always a tricky process, even experienced importers can run into roadblocks.
What happens when your supplier requests a letter of credit (LC) to protect them against non-payment on shipping? Let’s take a look.
SEE ALSO: Trade Credit Insurance – What is it & how to protect from losses?
It’s safe to say that if you’re running a business it’s unlikely you’re an expert at structuring supplier payments using mechanisms such as a letter of credit through the bank.
The process can be a bit daunting from the start, as the bank will send you an “application for a documentary credit” and you will be required to complete all the terms yourself such as the terms (FOB, CFR, CIF etc.), if it’s irrevocable or non-irrevocable, transferable and the list goes on.
The bank will need security or cash to raise the LC
The moment you make an enquiry with your bank to raise an LC they will ask you to open up a foreign currency deposit account to place the funds needed either in USD, EUR etc. for payment to the supplier. If you don’t have the cash to put up you may be able to offer security over a property, which can increase the time it takes to get the LC raised, as they will need to make an assessment on the security offered.
You forgot about the foreign exchange (FX)
When you raise the LC to the supplier, the deposit needed for the bank to raise the LC will need to be in the currency your paying in. This means that on day one, you will need to convert your AUD into the USD etc. You will now be holding USD (for example) on deposit with your Australian bank until the supplier ships the goods.
This creates a foreign exchange currency risk. For small amounts it’s not such an issue however if you are holding larger amounts and for some reason you need to cancel the LC, you will need to change the security deposit back into AUD. If the currency fluctuates you could risk losing money. It can also move in your favor, although I doubt you’re a part-time currency trader.
Keep this is mind and enquire with your bank or FX provider about hedging your position to limit the risk of losing money on currency fluctuations.
What if I don’t have the security or the cash?
Almost always you’ll approach the bank, and without sufficient security or cash to offer, the answer will be a no. The two most common types of scenarios are either your purchasing pre-sold goods or ranging inventory lines that are not pre-sold to buyers. There are of course lots of situations where you’re buying raw goods or components to be assembled, then on sold to customers.
For businesses that are buying pre-sold goods with valid purchase orders from credit worthy buyers you can access purchase order finance, sometimes called import funding. The financier will fund you based on the strength of the transaction, taking into account the strength of your buyer and the type of goods you want to finance.
This type of finance is very easy to qualify for given you meet the right conditions for the transactions and doesn’t require any property security or financial information.
Funding options are increasingly specialised with banks and other providers actively lending. Pairing the correct funding source based on your specific needs as an importer or exporter is extremely important. A number of lenders aren’t experienced in services that are appropriate to the import/export industry — Lloyd Guy - Director, Global Trade Finance Group Pty Ltd
If you’re buying stock/inventory that isn’t pre-sold, you can access inventory finance. This product works a bit differently to the purchase order funding simply because they allow the finance approvals without you having pre-sold the stock. The financier will look more heavily at your trading history, credit file and profitability as their risk is increased in case you are unable to sell the stock to repay the finance.
In both cases above the financier will pay your supplier/s direct to limit the risk and ensure a smooth payment process.
Who takes care of the letter of credit then?
Aside from the obvious benefit of having the finance company provide the cash needed to raise the letter of credit (LC) you my also get their expertise in structuring the LC, negotiating with the bank and your supplier to get the terms correct. On top of this, they also take care of the FX, which is usually going to get you more favourable rates than what you could achieve as they would have higher volume discounts etc. Keep in mind, in most cases they won’t provide any FX risk protection if the currency moves, make sure you ask your financier first.
Using these finance options to get your LC raised provides many hidden benefits on top of simply providing you the cash. One thing that should be pointed out, is the fact that financiers will not always have sufficient expertise in your industry. Sourcing outside help from an experienced import/export consultant can save you from serious headaches.
One last thing worth mentioning, good finance providers my also organise inspections services (sometimes these are mandatory by the financier depending on the goods). These can be from factory audits, pre-loading, container stuffing or mid-production checks which will give you the comfort of knowing your goods are going to arrive according to specification and add another layer of protection to the overall transaction.
If you’re new to import/export or an experienced outfit, it pays to get your situation reviewed to ensure you’re keeping up with changes in the industry.