Letters of Credit

What is a Letter of Credit?

letter of credit is a document that assures payment to a seller of goods primarily used for facilitating trade financing through purchase order financing. The seller receives reimbursement from the buyer or the buyer’s financial institution. The document serves mostly as a guarantee to the seller that it will be paid by the issuer of the letter of credit regardless of whether the buyer ultimately fails to pay.

In this way, the risk that the buyer will fail to pay is transferred from the seller to the letter of credit’s issuer. The letter of credit also ensures that the supplier meets all the agreed upon standards and quality of goods.

Letters of Credit Wine Beer and Spirits

Benefits of Letters of Credit

How does a Letter of Credit Work?

A common need is for a distributor or wholesaler who needs to import finished goods to fill purchase orders. They usually need a letter of credit issued by their supplier. In this scenario, purchase order funding is a feasible option.  The PO financer will require an inspection of goods before the supplier can cash in on the letter of credit.

In a purchase order funding deal, a factor will buy or issue a letter of credit for whatever materials a company needs but isn’t able to afford or do not want to pay for with their own money. PO funding deals often involve the purchase of raw materials necessary to manufacture a product to sell to individuals or other businesses.

These materials (or products) will be shipped to the business working with the factor. They will then manufacture the product and send it to the customer. The factor receives the payment after selling the products. The best thing about this arrangement is that it is possible without a company having to take on any new debt.

Mostly, the supplier is relying on the credit and guarantee of the factor for payment of the goods.  In a supplier guarantee, the vendor must at least agree to produce the goods initially. After manufacturing the products, the factor can provide two different guarantees to the vendor:

  • Upon receipt of funds from the factor, the supplier agrees to ship the goods directly to the end user.
  • The factoring company will guarantee the vendor that once the goods have been shipped, and accepted by the end user, that funds generated from the factoring of the invoice will be wired directly to the supplier. The balance between payment of the purchase order and the gross amount of the invoice will then be wired to you.

In both instances, a one-page triparty agreement is put in place between the factor, you, and the vendor. Factors have much experience in negotiating with the vendor, and most are pleased to have the guarantee in place.

A Letter of Credit Process Example

Let’s say you are in the t-shirt business. Your company receives a large t-shirt order from a big-box retailer like Wal-Mart. It would be best if you bought the raw goods from your supplier, but the supplier will not ship the goods.  Why would they not send the products?

Perhaps you are a young startup, or it’s the most important order you have ever placed with them. You do not have enough credit to supply all the goods to fulfill the order. They have cold feet, and that is when a vendor guarantee comes into play.

A factoring company with excellent credit can leverage your accounts receivables through invoice factoring.  A creditworthy factor with the proper experience can work directly with your supplier to guarantee they receive the payment.  You land a massive order from Wal-Mart, and your vendor gets a cash guarantee. It can be the perfect win-win-win scenario all parties involved are looking for.

The factor purchases your accounts receivables from the large order and pays your supplier before paying you. They advanced your t-shirt company up to 85% of your invoice amount. You received the remainder, less the factoring companies fee once the company pays the invoice in full.

The supplier is taking a risk if the order is not complete on time. The supplier will only consider doing this type of transaction if the relationship between all parties is excellent, and they are easy payment will be made on time.

When a company has a tremendous opportunity and has good relationships with their supplier, vendor guarantees can get you the critical working capital you need to grow your business.

For over 25 years, Paragon Financial Group has provided working capital solutions for growing companies throughout the US. We serve small to large-size companies across a wide variety of industries through accounts receivable, invoice factoring, and purchase order financing up to $10 million per month in volume. Paragon is a leading source of receivables financing, government contract financing, payroll funding, import financing, and purchase order financing.

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