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Open account, L/C - Coggle Diagram
Open account
Importers
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Disadvantages
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Currency Exchange Risk – If payments are due in foreign currency, exchange rate fluctuations can affect costs.
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L/C
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Importers
Advantages
Facilitates Trade with Unknown Partners:
Even when dealing with new suppliers, an L/C provides assurance that the exporter will be paid only after fulfilling the agreed conditions.
Control Over Transaction:
Importers can specify detailed terms and conditions in the L/C, ensuring that all contractual obligations are met before releasing funds.
Risk Mitigation:
The L/C reduces the risk of receiving non-conforming or inferior goods because the bank’s involvement adds an extra layer of verification.
Conditional Payment:
Payment is only made once the exporter meets all the terms and conditions, ensuring that the goods or services comply with the contract.
Disadvantages
Costly Process:
Banks charge fees for issuing and amending L/Cs, which can add to the overall cost of the transaction.
Complex Administration:
The process involves a significant amount of paperwork and coordination between multiple parties (banks, exporters, and sometimes insurers).
Inflexibility:
Once the L/C is issued, any changes to the transaction may require formal amendments, leading to delays.
Dependence on Bank’s Reliability:
The importer is reliant on the bank’s ability to process and honor the L/C, meaning that any issues with the bank could affect the transaction.
Exporters
Advantages
Payment Security:
The issuing bank guarantees payment provided that all stipulated documents are presented, reducing the risk of non-payment by the importer.
Reduced Credit Risk:
With the bank’s backing, exporters face less risk compared to open account transactions.
Financing Opportunities:
Exporters can often use the L/C as collateral to obtain trade financing or discount it at a bank.
Enhanced Credibility:
Working with reputable banks increases trust, opening doors to new markets and customers.
Disadvantages
Strict Documentation Requirements:
Any discrepancies in documents can lead to delays or non-payment, even if the underlying transaction is valid.
High Bank Fees:
Costs associated with issuing, advising, and confirming the L/C can be significant.
Administrative Burden:
Managing the documentation and meeting strict compliance deadlines can be complex and time-consuming.
Limited Flexibility:
Once terms are set, making amendments can be difficult and costly, potentially impacting the shipment timeline.
Definition
A Letter of Credit (L/C) is a financial instrument issued by a bank that guarantees a seller will receive payment from a buyer, provided that the seller meets specific conditions outlined in the L/C. It is commonly used in international trade to reduce risks for both buyers and sellers.