Chapter 14 – Open Your L/C

After you have issued your P/O to your factory and they in return issue their Performa Invoice, there is one more important action to be taken. Opening your L/C to your factory or your supplier. Be aware that nothing will be arranged by the factory without first receiving your L/C, especially if your business relationship with the factory is still in its infancy.

Cash is King to the Factory

The cash flow of many factories has become very tight in the last couple of years. They simply do not have money to finance material procurements and the labor costs by themselves. I had already mentioned that they have to pay for components and raw material in advance or upon delivery. And their workers will leave if they do not get paid.

So what actually is a L/C? Exporter and importer conclude a sales contract with the method payment will be made. This is usually by Letter of Credit (documented credit).

A L/C can be thought of as a letter from the importer’s bank informing an exporter that they will be paid for a shipment upon presentation of specific documentation. All communication takes place within banking channels. Bankers are not industrial experts and will not make decisions outside of what is documented in the L/C. If the L/C  contains discrepancies it can dramatically impede everything.

For example, you want to import a shipment of clothing and the seller (exporter) asks for a L/C. You accept the exporter’s terms and need to apply for a L/C from your bank in favor of the seller. L/Cs usually state a time period and manner in which the exporter must provide documentary proof that they have shipped the goods. Other obligations may also be included.

Obtaining an L/C

Obtaining a L/C is not as simple as just asking for one. Your bank is pledging to pay the exporter on your behalf, so you will be required by your bank to demonstrate that they will be able to recover the funds from you.

Once it has agreed to open a L/C, the opening bank (the importer’s bank) will transmit the L/C to its branch or correspondent (the advising bank) closest to the exporter. The advising bank will notify the exporter that credit has been established in their name after receiving the L/C.

Exporters should make sure that they are capable of meeting the terms and conditions of a L/C upon receiving it. This is very important because if the shipment does not match the description in the L/C, payment will be delayed in most cases until the discrepancy is resolved.

Since that may be time consuming and time is what you don’t have if you want to be among the first importing new products, you should use the following method to avoid such unnecessary delays.

Before your L/C is officially opened, send your draft to the (exporter) and let them check it. If amendments are needed, you simply correct your L/C draft before you pass it to your bank for processing. Since both parties will have checked the content before, everything should be fine and no delay will occur.

After shipment and presentation of the necessary documentation to the advising bank, if no discrepancies are found, the exporter is due payment. The paying bank could be the advising bank and thus the exporter can receive payment very quickly. If the opening bank is the paying bank, payment may take a few days. Both importers and exporters may request that the paying bank be in their country as they are looking to the L/C to protect their interests.

L/Cs Are Irrevocable

Importers can ask for any legal terms to be included within the L/C and exporters must provide documentary evidence to prove that such terms have been met. As most L/Cs are irrevocable, once a L/C has been opened and advisement has been made, they cannot be altered or cancelled without the consent of the exporter.

On the occasion when an exporter doubts the solvency of an opening bank, they can request having the L/C confirmed by the advising bank. This means that if the opening bank is responsible for making payment and cannot do so, the confirming bank will pay. For a cost of approximately 1% of the cost of the L/C an exporter receives a fair amount of added assurance.

In summary, an L/C is:

  • A formal document of payment
  • Opened by a party wishing to import
  • Communicated through banking channels
  • Paid by the opening bank within a specified timeframe upon presentation of stipulated documentation

The cost of a L/C to an importer is often a fixed fee plus a percentage or a percentage with a minimum commission. Additionally, exporters will be required to pay a variety of costs. When a L/C is not payable on sight, costs increase. This is also the case where more than two banks are involved, exporters request confirmation of credit, and when discrepancies are found within the documentation, and additions/changes to the L/C are necessary. There are different kinds of L/C but the most common one is L/C at sight. Other forms of L/C delay payment until a later day, after 30, 60, 90, or 120 days. You will however find, that factories cannot afford these payment terms because it seriously impacts their cash flow.

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