Forms of Short-term Financing/Bank Financing
Letters of Credit
Letters of credit are often used to finance purchases in a foreign transaction. Letters of credit are the guarantee of payment by the buyer’s bank (not the buyer) to pay provided the terms of the letter of credit are strictly met. Letters of credit can provide extended payment terms and still provide a guarantee of payment by the buyer’s bank, by accepting to pay the draft at maturity. This action is the source of a banker’s acceptance, which draws its name from the accepted draft. A banker's acceptance is a method of financing that banks can use to provide customers with short-term (six months or shorter) financing for trade transactions. A banker's acceptance is a time draft drawn on and accepted by a bank. The bank indicates its commitment to pay the stated amount of the draft on a specified future date by signing the draft on its face and thereby accepting it. The draft may then be sold to an investor for a money-market rate of return based on the credit risk of the bank. Acceptances may be less expensive than more traditional trade financing methods.
Acceptance financing has been used for decades as a form of bank loan. The ability to fix rates for periods of up to 180 days protects a borrower from adverse movements in interest rates up to six months. Banks offer banker’s acceptances in a wide range of maturities to match customers’ sales cycles and payment terms. Traditionally, importers used banker’s acceptances to finance imports into the United States. Today acceptance financing is used to finance a wide- range of activity such as imports, exports, domestic shipments, domestic purchases, and commodity warehousing of readily marketable products.
Banker’s acceptances provide a deferred payment option for a buyer but little benefit for a seller. Banker’s acceptances can be discounted to the seller freeing up funds to the seller and providing an additional income opportunity for the discounting bank. The fees and charges for discounting banker’s acceptances can be paid for by either the buyer or the seller. The accepted draft is discounted to the seller who receives a discounted amount from the bank discounting the draft. If the buyer agrees to pay for the discount fees and charges, the seller will receive the full amount of the draft, which is the reason it is important to establish who is responsible for these fees and charges in the negotiation process prior to fixing the product price. It is important to note that discounting can be done by either the buyer’s or the seller’s bank. It is possible that neither will be interested in discounting the draft, but in most cases both are available and should be confirmed before the transaction is finalized between the buyer and the seller. Whether the buyer, the seller, or their banks furnish the financing under letters of credit depends on a number of factors:
- relative negotiating position of the buyer and the seller
- availability of financing in the buyer’s and seller’s countries
- relative interest rates in the buyer’s and seller’s countries
- relative need of the buyer and seller for financing
Standby Letter of Credit
Standby letters of credit are instruments that stand by to pay if there is non-performance by a party in the transaction. Commercial sellers will accept a standby letter of credit to extend credit and to guarantee payment if the buyer does not pay. It is paid for by the buyer and issued by the buyer’s bank against the credit facility the buyer has with his or her bank. It provides the seller with the comfort of collecting against the standby letter of credit should the buyer not pay according to agreed upon payment terms. The seller should never extend more credit in the form of shipments to the buyer than the amount of the standby letter of credit because the seller is only protected up to the amount of the standby letter of credit.
Transferable Letter of Credit
Transferable letters of credit can be a very valuable financing option but are often misunderstood and improperly executed. The first task is to identify the parties in the transaction. There is an ultimate buyer and an ultimate seller, and between them in the transaction is a broker/sales representative. The broker can represent himself in the transaction or be a distributor for a much larger, well- known company. Using a transferable letter of credit, the broker requires no credit facility or collateral for his role in the transaction, making this action very valuable for the broker.
The process works in the following way: A buyer issues a transferable letter of credit to the broker; then the broker transfers to the ultimate seller of the goods the cost of the goods to be shipped. The seller now has the responsibility to make the complete shipment to the ultimate buyer. The broker will never take title to the goods; it passes directly to the ultimate buyer. The seller of the goods is happy because he/she is a party to the letter of credit and is guaranteed payment by the buyer’s bank. The buyer is happy because he/she receives the goods under strict compliance of the letter of credit (note that this transaction does not prevent fraud). The broker is required only to replace the seller’s invoice with his/her marked-up invoice (the profit) when the seller’s documents are presented to the transferring bank; these documents are in turn forwarded to the paying bank with the replaced invoice so that the broker can secure his/her profit in the transaction. This situation appears to be too good to be true. There is, however, risk. The risk is that the ultimate buyer will be able to identify the seller in the transaction and be able to eliminate the broker. This situation can be controlled by carefully structuring the documents in the preparation of the transferable letter of credit and the packaging of the product. When the broker is a distributor, however, it does not matter that the seller is disclosed.
For example, take the case of a name brand like Levi’s. A buyer knows the maker of the goods but cannot acquire them directly from the manufacturer. The broker is protected by an exclusive distribution contract with the manufacturer (Levi Strauss & Co). The benefits for the broker are now obvious: there is no financing necessary and no need for warehousing a product. The broker has the responsibility for finding a manufacturer for the buyer and preparing an invoice to correspond to the negotiated sale between the ultimate buyer and seller.
Transferable letters of credit should not be confused with a back-to-back letter of credit.