Practical aspects of Letter of credit

Background:

In the corporate world , you might have heard the word “Letter of credit or LC” . LC is really wide subject. I have try to cover Practical aspects of Letter of credit. Trust me this post is very useful to understand end to end cycle of letter of credit.

Letter of credit which is mostly know as LC  in short form.Letter of Credit (here in after refer as LC) is one type credit facility provided by bank to the customer.

Definition and requirement of LC:

Letter of credit is an undertaking given by buyer’s bank to supplier’s bank that buyer will pay money on due date.In simple language, If one has to purchase any goods from the seller then same can be purchase in simple credit terms but same can be purchased through LC .In some case buyer may not be known persons for seller hence seller insist to supply goods against LC only. Hence we can say that there four parties involved in LC transactions viz., Buyer, Buyer’s Bank which can be said applicant bank and seller i.e. beneficiary and his bank which is know as beneficiary bank.

Credit Facilities – Practical aspects of Letter of credit:

Credit facilities can be bifurcated in mainly two parts viz. Fund base limit and non fund base limit.Cash Credit,Term Loan etc. are fund base limit where as LC and Bank Guarantee (BG) are non fund base limit.

i. Fund Base Limit:

Bank transfer the fund to the customer account which can be short term or long term liability for customer. e.g. one has applied for cash credit with their bank then bank will disburse the fund as per limit.

ii. Non Base Limit: 

Here customer request for opening of LC or BG to their bank. Here our bank is giving undertaking to beneficiary bank that customer will pay money on due date. e.g. 180 days from Bill of Lading.Here liability to pay fund arise only on due date and not before hence it is called as Non fund base limit.

Type of Letter of Credit (LC):

There are two type of LC  viz., Inland LC and Foreign LC and there could be usance LC and Sight LC.

Process of Letter of Credit (LC):

1. Buyer negotiates with seller for purchase of good and sign either purchase order or agreement.
2. Purchase order or agreement is base document to open LC.
3. Buyer applies for LC in prescribed LC form which requires to be stamped .
4. Buyer can apply for LC for the purchase but subject to maximum amount as per LC limit with bank .
5. Buyer has to submit duly filled LC form, Purchase order, Insurance copy for goods in transit as per payment term. e.g. payment term is 60 days from Lorry Receipt (LR)
6. Bank will open LC after verifying necessary documents and taking margin money (i.e. Fixed deposit) on LC amount.
7. Generally bank prepared LC in four copies. For each of parties as mention above.
8. Seller receives LC number and LC document from their bank and supply goods against LC
9. Seller will draw bill of exchange equal to  the amount of goods supply along with  original Invoices and delivery proof (LR,RR,BL,AB) and submit the same to his bank who in turn submit to us via our bank.
10. Buyer will give acceptance to bill of exchange that he will pay money on due date to his bank.
11. In same line Applicant bank give undertaking to beneficiary bank that they will pay money on due date
12. Buyer of good pay money to his bank on due date and get original invoices and supporting document.
13. Unique thing about LC is that whether buyer will pay money to his bank or not but applicant bank has to make payment to beneficiary bank .
14. Here if buyer will  not pay to bank then he is liable to pay interest and charges to their bank.
15. Not paying money to bank on due date of LC Payment is like dishonouring cheque . You have to consider this Practical aspects of Letter of credit . 

You can check RBI Website for latest circular regarding Non Fund Limit 

Hope you get clarity regarding Practical aspects of Letter of credit. The way you manage company’s fund , it requires similar disciple for your personal finance too. Do read our post How to do Money Management?