Letter of Credit
Definition:
A letter of credit (LC) is defined as Realising payment under a Letter of Credit in the event that a buyer defaults, becomes insolvent, or files for bankruptcy is known as liquidation. It guarantees payment for delivered products or services to a seller, typically a small or medium-sized business (SME), even in the event that the buyer is unable to pay. The seller can preserve cash flow, lower bad debt, and preserve financial stability during liquidation events by submitting compliant documentation, which the issuing bank will honour.
A Letter of Credit: What Is It?
A bank will issue a Letter of Credit (LC), which is a financial document that assures a seller that the buyer will pay them as long as the terms are fulfilled. An LC, which is frequently used in both domestic and international trade, guarantees that payment will be made as soon as the seller provides the bank with the necessary shipping and business documentation. This tool lowers credit risk and provides SMEs with certainty in high-value or international transactions.
In the context of letters of credit, what does liquidation mean?
When a buyer is unable to meet their financial obligations because of insolvency, default, or bankruptcy, the act of claiming payment under an LC is known as liquidation. As long as the conditions of the LC are met, the bank, acting on behalf of the buyer, pays the seller. For SMEs with limited cash flow that cannot afford non-payment losses, this approach is essential.
Why It's Important for SMEs to Liquidate Letters of Credit
Trade protection: guarantees the safety of payments in domestic and foreign transactions.
Receivables are guaranteed by cash flow assurance, even in cases of buyer insolvency.
Risk mitigation protects SMEs against geopolitical threats, default, and fluctuations in foreign exchange.
Financial Access: LCs may be used as security for trade or working capital loans.
Market expansion allows SMEs to safely interact with riskier markets and new customers.
The Process of Letter of Credit Liquidation
Buyer fails or is deemed insolvent as the trigger event.
Seller Action: In accordance with the LC, the seller provides their bank with the necessary paperwork.
Bank Review: The issuing bank confirms that the provisions of the LC are being followed.
Payment Release: Money is given to the seller, frequently supported by collateral from the buyer.
Reporting and Closing: Transactions are recorded, particularly those supported by the government or SBA.
LC Liquidation's Principal Advantages
Better Liquidity: Guards against unforeseen delays in payments.
Reduced Bad Debt: Lessens the likelihood of bills that cannot be collected.
Financing Leverage: Facilitates invoice financing and trade credit access.
Confident forecasting and operational planning are made possible by predictable revenue.
Increased Buyer Trust: Establishes reputation with bigger or foreign clients.
Real-World Examples
During shaky economic times, an Indian clothing exporter secured payments from European customers by using LCs with liquidation terms.
SMEs with LC-backed sales experienced fewer defaults and continued to operate steadily during the COVID-19 pandemic.
Southeast Asian manufacturing companies have recovered debts from troubled foreign buyers through LC liquidation without resorting to judicial action.
FAQs
1. How does a Letter of Credit operate and what is it?
If the terms of the transaction are fulfilled, a bank guarantee known as a Letter of Credit guarantees payment to the seller. When the seller presents the necessary paperwork, the bank takes over and pays the vendor.
2. What causes the liquidation of LC?
When a buyer defaults, becomes bankrupt, or enters liquidation, LC liquidation is initiated. Under the LC, the seller submits a payment claim to the issuing bank.
3. What is the significance of LC liquidation for SMEs?
It ensures cash flow, shields SMEs from non-payment concerns, and gives them confidence when interacting with foreign or new buyers.
4. Can SMEs get financing against an LC?
Indeed. SMEs can secure pre-shipment or post-shipment finance using an LC as collateral, improving liquidity without additional debt.
5. What does LC liquidation cost?
Banks typically charge 1.5% to 8% of the LC value, depending on risk and transaction complexity.