What Is Full Form Of LC?
The full form of LC is a Letter of credit. A letter of creditLetter Of CreditA Letter of Credit (LC) is issued by a buyer’s bank to ensure timely, full payment to the seller. If the buyers default, the bank pays the sellers on their behalf. is used mostly in international transactions where the document the buyer’s bank gives, known as the issuing bank, guarantees that the buyer will pay the seller the correct amount. If the buyer fails to pay the amount to the seller, the bank must pay the outstanding dues on the buyer’s behalf.
Thus, it is a contractual document through which the buyer commits to the seller that they will pay the amount due on time. It is a tool that can be used to protect the seller and the buyer who enter an agreement to transact any product or service. This payment concept boosts foreign trade and helps in establishing good trade relation among countries.
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How Does It Work?
The full form of LC is Letter Of Credit, which is a document issued by the bank of the buyer that states that the buyer of goods and services will make the payment of the same on time and if they are not able to do so, then the bank will make the payment on their behalf.
This process as explained in the full form of LC in banking, gets initiated once the seller of the goods ship them and provide the required documents as proof that the products have been sent and the payment is to be made within the credit period. This financial process is frequently used in case international transactions, where the goods are transferred from one country to another.
The points given below explains how the process is conducted in different steps and finally the payment is transferred by the buyer to the seller.
- The buyer must approach the bank in his home country for its issuance and provide various information such as payment amount, date of shipping of goods, mode of shipment, arrival time and place of shipment, details of the seller, etc., to get the letter of credit.
- 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 seller’s bank, generally located in the home country of the seller.
- After receiving the LC, the seller’s bank will verify it and forward it to the seller. Then, the seller 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 delivered goods are as specified, the seller will get the payment within the time mentioned in the LC.
As explained in the full form of LC in banking, it gives motivation to do international business because the bank provides a guarantee that the payments will be made. In spite of all that, it faces some restrictions due to the fact that there are a good number of fees that banks charge. Therefore, very often, it is used in case the parties are totally new to each other, the transactions involve risky or very high-value items, or both businesses are comparatively new.
The traders are comfortable in paying high amount of fees to banks in order to secure their goods exchange due to the above reasons. So, over the years, it has proved to be very useful tool and will continue to do so as traders from different countries try to enter into more high-value trades with each other.
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 Revocable 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 quickly from one party to another. However, LC is negotiable if issued as an unconditional promise to pay the amount on demand at a given time.
Here, it should be noted that the tool, which explains the LC full form in business, is issued against a fee that banks charge for the service. It is usually a particular percentage of the total value of the goods that they are protecting regarding payment guarantee. However, the percentage may vary from bank to bank. The fee can also depend on the type of transaction, which means whether it is within the country or international. Banks issuing a confirmed LC usually charge a higher fee as compared to an unconfirmed one.
The different types of the 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 beneficiary permission.
- Transferable LC – This type of LC is allowed to be transferred by the seller to other parties and acts as money.
Let us understand the concept of LC full form in business, with the help of a suitable example, as given below:
Mr. Edward, a clothes business named Textile Incorporation located in the USA, received an order of clothes worth $20,000 from a company named Clothing Incorporation located in London. The clothing incorporation was 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 that 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 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 and services and is the recipient of the amount in a business transaction. The beneficiary will provide all the documents 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. If the applicant fails to pay the money to the beneficiary, the issuing bank must pay on the applicant’s behalf.
- 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.
Over the years, it has proved to be a very useful financial instrument due to the above reasons.
- LC helps do trustworthy business worldwide by reducing 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 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.
Some important advantages of this financial tool of LC full form in finance are given below:
- When the LC is issued, there is a high chance that the money may be received on time by the seller. Thereby reducing the risk to the seller.
- One can easily sort out any discrepancy or dispute following the banking regulations that apply to issuing LC.
- Due to the above reasons, it creates mutual trust and faith among the buyer and seller, which is crucial in the development of trade relations, especially if it is international.
- The document clearly specifies the various terms and conditions of transaction and procedure of payment. This ensures clarity regarding the entire process.
- The fund transfer process becomes very streamlines and fast, with very least chance of the amount becoming a bad debt. It increases the efficiency of the transaction.
Here are some disadvantages of the concept of LC full form in finance, which should be understood in detail.
- The cost of taking a letter of credit is comparatively higher. It consumes more time as it requires many formalities.
- LC ignores currency fluctuation as it does not consider the difference in the rate between the date of contract/sale and the date of payment.
- The buyer has to take the responsibility of paying the cost of the LC, which is a financial obligation.
- In case the document does not mention all minute details, then it may create miscommunication and error.
- Any changes in political of economic policy within the countries may create hassles in handling and processing of the LC.
Thus, a Letter of Credit (LC) is required to have international transactions smoothly. One should understand the regulations and formalities well before making any commitments. A Letter of Credit helps to improve 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 article is a guide to the Full Form of LC, i.e. (Letter of Credit). Here, we discuss how LC works, its types, features, examples, advantages, and limitations. You may refer to the following articles to learn more about finance: –