What it means
When you buy goods from a supplier you have never met before, especially overseas, trust is a major hurdle. The supplier worries you will take the goods and not pay, while you worry you will pay upfront and never receive the goods.
A letter of credit solves this dilemma by placing a reputable bank in the middle of the transaction. To set this up, the buyer requests a letter of credit from their bank.
This document is sent to the seller's bank. It states that the bank will release funds to the seller as soon as they present specific shipping documents proving the goods are on their way.
This guarantees payment for the seller and ensures the buyer only pays when the shipment is verified. This tool is vital for business growth because it removes the risk of non-payment.
It allows companies to trade with international partners without needing to trust them blindly or rely entirely on risky advance payments. While banks charge fees for this service, the security it provides is usually worth the cost, especially for large inventory orders.
In practice
Real-world examples.
Example
A London fashion startup orders 5,000 cotton shirts from a factory in Turkey. To build trust, the startup uses a letter of credit, ensuring the Turkish factory gets paid immediately once shipping receipts are provided.
Example
A mid-sized manufacturing firm in Birmingham purchases specialised machinery from Germany worth 120,000 pounds. They use a bank letter of credit so the German vendor feels secure enough to dispatch the heavy equipment.
Example
An organic food distributor in Edinburgh imports vanilla pods from Madagascar. By using a letter of credit, they protect their cash flow, ensuring funds only leave their account when cargo arrival documents are verified.
Think of it
“Imagine selling your bicycle to a stranger online. Instead of handing over the bike for a promise, you both leave the cash and the bike with a trusted mutual friend. Once the friend sees the bike is handed over safely, they give the cash to you.
Formula
Calculation
Total Letter of Credit Cost = Issuance Fee + (Letter of Credit Amount multiplied by Interest Rate per Month multiplied by Duration in Months) + Advising Fee. For example, on a 50,000 pound order with a 1 percent issuance fee (500 pounds), a 0.5 percent monthly fee for 2 months (500 pounds), and a 50 pound advising fee, the total cost is 1,050 pounds.Case study
Seen in the real world.
Brighton Bicycle Co, a growing UK retailer, wanted to source custom bicycle frames from a new supplier in Taiwan. The order value was 80,000 pounds, and the supplier demanded a 50 percent upfront deposit before production could begin. Brighton Bicycle Co did not have enough spare cash for this and hesitated to send money to an overseas supplier they had never worked with before.
Instead, their finance manager suggested using a letter of credit through their high street bank. The bank issued a letter of credit stating it would pay the Taiwanese supplier 80,000 pounds upon presentation of official bill of lading documents showing the frames had been shipped.
This arrangement satisfied the supplier, who immediately began production without needing a cash deposit. Brighton Bicycle Co kept their cash reserves safely in their account until the shipment was verified and on the water. When the shipping documents arrived, the bank released the funds. Both parties completed a secure transaction, protecting cash flow and building a strong foundation for future orders.
Watch out
Common mistakes.
- Assuming the bank checks the quality of the actual goods, when banks only check paper documents.
- Failing to match the shipping documents precisely with the terms written in the letter of credit.
- Ignoring the bank fees and interest charges, which can reduce expected profit margins on tight orders.
Questions
People also ask.
What happens if the shipping documents have a typo?
Banks are very strict. Even a minor typo or spelling mistake in the shipping documents can cause the bank to withhold or delay payment until the error is corrected.
Who pays for the letter of credit fees?
Typically, the buyer pays for the issuance fees charged by their bank, while the seller may pay the advising fees charged by their local bank, though this is always negotiable.
Is a letter of credit the same as an escrow account?
No. An escrow account holds actual cash deposited in advance, whereas a letter of credit is a financial promise from a bank to pay using its own funds if conditions are met.
From the founder's library
Take it further with the book.
Build your financial confidence beyond this definition. Shihan's full-length guide, Accounting Fundamentals, takes the same plain-English approach and turns it into a complete, practical playbook for non-finance managers, business owners and students - with chapter-end quiz answers and presentation slides included.
25% off with code MMHQ25, applied at checkout. Priced in USD - checkout may show the equivalent in your local currency.
View the book and save 25%Related