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Letter of Credit (L/C) - Coggle Diagram
Letter of Credit (L/C)
Definition
a financial instrument issued by a bank on behalf of a buyer (importer) to guarantee payment to a seller (exporter), provided that the seller meets the terms and conditions specified in the L/C, including the submission of required shipping and transaction documents within a given timeframe.
Advantages
Seller (Exporter)
Access to Financing – The exporter can use the L/C as collateral to obtain loans or pre-shipment financing.
Improved Cash Flow Management – Since the payment is secured by a bank, the exporter can plan financial operations more effectively.
Guaranteed Payment – The bank ensures that payment will be made as long as the seller meets the L/C conditions.
Expands Market Opportunities – The use of L/C allows exporters to trade with new or high-risk markets with confidence.
Buyer (Importer)
Better Control Over Transactions – The buyer can specify conditions in the L/C, such as shipment deadlines and required documentation.
Deferred Payment Option – Some types of L/Cs allow delayed payment, helping the importer manage cash flow.
Payment Security – The importer only pays if the seller provides the correct documents, reducing fraud risks.
Disadvantages
Seller (Exporter)
Strict Documentation Requirements – The exporter must provide accurate and complete documents. Any mistake or missing document can lead to non-payment.text
Bank Charges – The exporter has to pay fees for document processing and L/C confirmation (if required).
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Complicated Dispute Resolution – If a dispute arises, resolving it through banks and legal channels can be costly and time-intensive.
Buyer (Importer)
High Banking Fees – The importer must pay issuance fees, amendment fees, and other banking charges, increasing transaction costs.
Financial Obligation – Once the L/C is issued, the importer is legally bound to pay if the documents comply, regardless of potential quality issues with the goods.
Limited Flexibility – Any change in the order (e.g., quantity, delivery time) may require amendments, which are costly and time-consuming.
Delays in Shipment – The time taken for document verification and bank processing can cause shipment and payment delays.
Risk of Fake or Low-Quality Goods – The bank only checks documents, not the actual goods, so the importer may receive defective or non-compliant products.
Types
Transferable L/C – Allows the original beneficiary (seller) to transfer all or part of the L/C value to another party, often used by intermediaries or traders.
Confirmed L/C – A second bank (confirming bank) guarantees payment in addition to the issuing bank, reducing the risk for the exporter, especially in high-risk countries.
Irrevocable L/C – Cannot be changed or canceled without the agreement of all parties involved, providing stronger security for the seller.
Sight L/C – Payment is made immediately (or within a few days) after the bank verifies that the documents comply with the L/C terms.
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Usance (Deferred) L/C – Payment is made at a future date after document submission, giving the buyer extra time before paying.