How to buy Goods by Letter of Credit
What is a letter of credit?
A letter of credit (L/C) is a document which states all of the conditions of an order placed by you on the seller such as quantities, price, specification, packing, insurance, latest shipment date etc. You issue a letter of credit through your bank, which in turn send it to the seller’s bank, who will act on their behalf. It then becomes a document driven transaction between the two banks.
One of its key features is that your bank guarantees to the seller’s bank that it will remit the money for the goods on an agreed date once the documents which support it; e.g. invoices, insurance certificates, shipping documents etc. have been presented. Your bank does not concern itself with the goods themselves, only with the documents accompanying the shipment; if these are in order the bank will, (indeed must) pay.
Imagine that you have made contact with a supplier in Taiwan and you decide to place an order with them. Your negotiations will naturally focus on their prices but there will be other things to consider. How will the goods be shipped; will they will be sent on time; who pays the shipping charges; are the goods insured; will the goods be packed according to your needs and do they conform to EC & UK consumer safety regulations? All such matters must also be settled.
You must obtain written confirmation of your agreement on all of the above points before you can instruct our bank to issue the L/C. The bank in turn will list the documents it will require to be presented, as proof of the seller’s compliance with this agreement before payment can be made. If there is any breach of the terms (e.g. if the goods were shipped too late or there is no EC or approved certificate to prove they comply with safety rules), you have the right to repudiate, leaving the seller with goods in the UK and egg all over their face.
Letters of credit and cashflow
Unlike buying from a UK supplier where you can expect a reasonable period of credit from the date of delivery of goods before being called upon to pay their invoice, an L/C almost always calls for the money to be deducted by the bank from your funds (or added to your overdraft), at the time that it is issued. This should not be surprising given that the bank is entering into an irrevocable agreement to pay the L/C once all of the documents are presented.
If the seller is based say in Taiwan, it will take at least a month for the goods to be shipped to the UK and if the order has to be manufactured first, however long that takes will be added to the period between the cash being deducted from your account by your bank and their arrival.
This means that if it takes a month to manufacture and another month to deliver, you will have in effect paid for the goods two months ahead of them coming through your door.
The documents against which your bank will pay are mostly specified by you when the L/C is raised but a key document is the one raised by the shipper once the goods are loaded, that transfers their ownership from the seller to you upon their arrival in the UK - “the document of title”.
The document of title
When goods are shipped by sea the details of each individual consignment is recorded on a shipping document, known as a “bill of lading”, this is the document of title. The bill of lading is raised when your order has been loaded onto a ship. Once the ship has sailed, copies of this and all of the other documents you have called for on the L/C are sent to your bank, which then notifies you of their arrival. It is important to note that it is impossible to take possession of your goods without the bill of lading.
If goods are shipped by air then an “airway bill” substitutes for the bill of lading and a “trucking receipt” if the goods are shipped by road.
Will the L/C cover the freight & delivery charges?
This depends entirely on what you agreed with the supplier when you struck the deal. The principal terms when it comes to shipping goods are – ex works, fob, c&f, and cif. Whichever of these you have agreed with the seller become part of the conditions of your order and will be specified on the L/C. The definitions of the most common terms are as follows:
“ex works” all the costs of shipment from the seller’s factory or warehouse will be borne by you.
“fob” (free on board), they will pay for the delivery of the goods on board the ship aircraft / truck; all other costs of shipment are borne by you.
“c&f” (carriage & freight), they will pay for the delivery on board the ship / aircraft / truck and the freight.
“cif” (carriage, insurance & freight), the same as above but they will also pay the cost of insurance.
As an example, if the terms are set at ex works, the L/C will be valued simply at the cost of the goods, because you are paying for all of the freight from the supplier’s premises. If however the terms are set at cif, the shipping and insurance charges will be included in the value of the L/C.
You will be expected to pay for the delivery of the goods from the port to your premises, plus clearance charges and import duty.
A good freight forwarder will take care of the complex, and sometimes long winded routines which clearing goods through customs involve and further will arrange for their delivery to your premises. It is not recommended that you try to do this yourself.
Exchange rate risk
The overwhelming choice of currency when it comes to pricing goods and services from outside the EC is the $. This might though involve a risk; i.e. that the exchange rate can rise or fall between the time you issue the L/C and when it is settled by your bank. This is best illustrated by the example below:
You are quoted in US$ and you place an order for: US$1000
The rate of exchange when you order is: £1.00 = US$1.60
When the time comes to pay the invoice the rate is: £1.00 = US$1.50.
When ordered your estimated landed cost is: £625.00.
When paid for your true landed cost is: £666.67.
The actual cost of your goods once you have paid for them will have therefore risen by 6.7% on your original calculation. If however the rate were to be US$1.70 when payment is made you would find that the landed cost will come out at £588.24, i.e. 5.9% cheaper.
There are a number of ways that you can sidestep this potential risk. You can arrange with your bank to “buy the currency forward.” You can do this when you issue the L/C or at any time afterwards and thereby secure a guaranteed rate which will apply when it is settled. This can sometimes be a better rate than the one ruling at the time that you secure it.
You can also hedge your bets yourself by assuming a less favourable rate than the one in force at the time you are calculating your prices. The question you should then ask yourself though is whether you are in business to sell your products or to indulge in currency speculation.
Is all this worth it?
You may wonder if all of the issues above make buying against L/C worthwhile. Your money can be tied up for months before you have sight of the goods, your bank has to be paid for the work that they are called upon do, goods will usually have to be purchased in foreign currencies, often the US$ and you will probably have to pay import duty and VAT up front on them once they land in the UK. As if this wasn’t enough, you may well need more finance or working capital in order to do all of this.
If however you have tracked down the right suppliers and L/Cs are called for, you will have no choice if you want to buy their merchandise. This is because it could well be that you will have products in front of you of superior specifications at the sort of prices that offer eye-watering opportunities for both sales and margins and if you don’t put them into your market, someone else will.
To put this to the test, go to your profitability webchart and having selected a percentage of goods purchased by L/C; add a few points to your gross profit margin to see what the effect on profits and net worth would be. When buying from overseas by L/C you should be able to realise much higher margins than from a regular supplier. If this is not the case then something is seriously wrong. You should also check your cashflow & liquidity report to establish whether you have sufficient cash for this and if not, what to do about it.
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