A letter of credit allows a company to substitute a bank’s credit for its own in a business transaction. The benefits of letters of credit include helping a company complete a business transaction without the use of cash or another form of payment. Another benefit is the completion of international business transactions that might be quite complex. The secondary benefits of letters of credit include flexibility, because there are two main types of letters: commercial and standby. A company can secure either type, depending on its need.
Commercial letters of credit are mostly a method to facilitate payments in an international business transaction. The letter acts as a contract between the bank writing the letter and another bank. The benefits of letters of credit for this purpose include allowing the second bank to make payments to a beneficiary. The beneficiary typically is the business providing the goods or services. For international transactions, the second bank might be in another country, allowing the transaction to go smoothly.
A standby letter of credit is slightly different. This letter of credit acts as a secondary payment system, outside of the primary payment system of cash or credit. Letters of credit written in the standby format are not actually going to be forms of payment. The letter simply states that the company has the ability to pay through a bank if the business cannot pay through a primary method. Essentially, the standby letter of credit shows a company’s creditworthiness in the business market.
Outside of these specific benefits to each letter of credit, other benefits of letters of credit exist. In most cases, the letters are negotiable. The bank issuing the letter might not actually pay but might allow its customer to transfer the note to another party. Revocable letters of credit can have changes or adjustments made to the language in the letter. Letters might also be a sight or time draft; sight drafts are payable upon presenting the letter to the bank, and a time draft pays only after a specific time period.
Though letters of credit are quite common, all businesses are not always able to secure them. The benefits of letters of credit come only to businesses that can be good customers for issuing banks. These companies are often large and have multiple payment methods. The letter of credit simply allows them to avoid initial cash payments for transactions. A letter of credit might last for a certain time period, so the business could use it repeatedly.