Full Form of LC
The full form of LC is a Letter of credit. A letter of creditLetter Of CreditA letter of credit is a payment mechanism in which the issuer's bank gives an economic guarantee to the exporter for the agreed payment amount if the buyer defaults. In international trade, buyers employ LC to reduce credit risk. is an instrument used mostly in international transactions where the document is given by the buyer’s bank, known as the issuing bank, that guarantees that the buyer will pay to the seller the correct amount timely and in case the buyer fails to pay the amount to the seller then the bank is liable to pay the outstanding dues to the seller on behalf of the buyer.
The features of the letter of credit are as follows –
- Revocability – The letter of credit can be revocable or irrevocable. Mostly the irrevocable LC is prevalent as it cannot be modified with all parties’ permission times, whereas if a bank issues Revocabl,e LC, then such a bank has the authority to revoke that LC issued at any time.
- Negotiability – the LC is considered an easily negotiable instrument and can be used as money as it can be passed on easily from one party to another. But LC is negotiable if it is issued as an unconditional promise to pay the amount on demand at a given point of time.
The different types of letter of credit are as follows –
- Irrevocable LC – This type of LC cannot be modified or canceled without the beneficiary’s prior approval.
- Revocable LC – This type of LC can be modified or canceled by the issuing bank without any beneficiary permission.
- Transferable LC – This type of LC is allowed to be transferred by the seller to other parties, and it acts as money.
How does it Work?
- For getting the letter of credit, the buyer has to approach the bank in his home country for its issuance and provide the various information that the bank might require like payment amount, date of shipping of goods, mode of shipment, arrival time, and place of shipment, details of the seller, etc.
- After getting the details and if found satisfactory, the bank will issue the LC, which is the promise to send the money to the seller, and then the bank will send the same to the bank of the seller, generally located in the home country of the seller.
- After receiving the LC, the seller’s bank will verify it and then forward it to the seller. The seller then has to verify that all the terms and conditions listed in LC match the agreed one with the buyer. Now, to receive the payment by the mode of LC, the seller has to satisfy all the LCs requirements.
- If all the conditions meet and the goods are delivered as specified, the seller will get the payment within the time, as mentioned in the LC.
Example of LC
Mr. Edward having a business of clothes named Textile incorporation located in the USA, received an order of clothes worth $20,000 from a company named Clothing Incorporation located in London. Now the clothing incorporation is new to MR. Edward, so he demanded a letter of credit. So the buyer asked the local bank to issue the LC to the seller bank, which is an instrument which is a guarantee given by the buyer’s bank, which says that if the buyer fails to repay the number of dues, then the issuing bank will pay on behalf of the buyer.
The Elements of the Letter of credit are as follows:
- Applicant – The applicant is the one who is the purchaser of goods or the receiver of the services in any business transactionAny Business TransactionA business transaction is the exchange of goods or services for cash with third parties (such as customers, vendors, etc.). The goods involved have monetary and tangible economic value, which may be recorded and presented in the company's financial statements..
- Beneficiary – The beneficiary is the one who sells the goods & services and is the recipient of the amount in a business transaction. All the documents are to be provided by the beneficiary to process the letter of credit.
- Issuing Bank – The issuing bank is the bank that issues a letter of credit upon receiving the parties’ satisfactory documents. In case the applicant fails to pay the money to the beneficiary, then the issuing bank has to pay on behalf of the applicant.
- Advising Bank – The advising bank is the bank that advises the beneficiary about the use and advantage of the letter of credit. The bank is responsible for sending the required documents to the issuing bank and has no obligation to clear the dues if the issuing bank fails to retire its obligations.
- Confirming Bank – The confirming bank has to confirm the LC and assumes obligations similar to that of the issuing bank. It also evaluates the country and the bank that issues LC before confirming the LC.
- LC helps in doing trustworthy business worldwide as it reduces the risk of bad debtsBad DebtsBad Debts can be described as unforeseen loss incurred by a business organization on account of non-fulfillment of agreed terms and conditions on account of sale of goods or services or repayment of any loan or other obligation..
- LC can even help a person to get pre-shipment finances from financial institutionsFinancial InstitutionsFinancial institutions refer to those organizations which provide business services and products related to financial or monetary transactions to their clients. Some of these are banks, NBFCs, investment companies, brokerage firms, insurance companies and trust corporations. and banks.
- When the LC is issued, there are high chances that the money can be received on time by the seller, thereby reducing risk to the seller.
- Any kind of discrepancy or dispute can be easily sorted out following the banking regulations that apply to issue LC.
- The cost of taking a letter of credit is comparatively higher, and it consumes more time as it requires many formalities.
- LC ignores currency fluctuation as it does not consider the difference in the rate that occurs between the date of contract/sale and the date of payment.
Thus, the letter of credit (LC) is required to have international transactions smoothly. The regulations and formalities should be understood well in advance before giving any commitments. A letter of credit helps to improve the business transactions worldwide as it reduces the risk of non-payment of dues. Thus the seller mostly demands a Letter of credit these days while exporting their goods.
This has been a guide to the Full Form of LC, i.e. (Letter of Credit). Here we discuss how does lc work, its types, features along with an example, advantages and limitations. You may refer to the following articles to learn more about finance –