Unless you have a special relationship, most suppliers require some assurance of payment for goods before they are produced and shipped to the importer or buyer. This assurance usually takes one of two forms:
1. Deposits and Contracts. Suppliers can obtain from the buyer a cash deposit, typically 30% of the value of the order, along with a purchase order or contract for the goods. While the purchase order is an enforceable contract, it can be very costly to enforce if the parties are in different countries, so the supplier will only have their cash deposit if the buyer does not fulfill their obligation to pay.
2. Letters of Credit and Contracts. In lieu of a cash deposit, suppliers can obtain from the buyer a letter of credit or bank guarantee, along with a purchase order or contract for purchase of goods. Although the supplier will typically not have a cash deposit in this scenario, they will have a promise of payment from a bank in addition to the buyer’s contractual obligation to pay. The likelihood that a bank will fail to meet the obligations set forth in a letter of credit are significantly less than the risk of default of a buyer; banks have more assets and are more reliable.
If you go with the first scenario, deposits and shipping costs can add up, leaving insufficient funds for operations. You can always minimize the size of your orders to avoid depleting your cash flow, but that would inhibit your growth since you may have to turn down large orders that offer significant opportunities to grow your business.
Another way to approach this issue is described in the second scenario where the buyer gives their supplier a commercial letter of credit instead of a deposit. A letter of credit is a conditional assurance of payment provided to the supplier’s bank when the import order is placed.
As a buyer, opening a commercial LC through a bank or financial institution gives you more comprehensive control over the process of importing your goods. It covers the cost of the goods themselves as well as shipping costs of your imports, allowing you to keep your money until the goods are received and approved. Although the letter of credit will cost more than leaving a deposit, which costs nothing, it allows you to avoid the cost and risk of tying up your funds.. With a letter of credit, if a supplier does not perform according to your instructions, you do not risk losing your deposit because you never left the deposit in the first place. If the supplier ships goods late or not according to spec, you have more leverage to negotiate a different price than if you had left a deposit because you will not have to risk losing your deposit if you cannot renegotiate satisfying terms.
In sum, a letter of credit ensures that you don’t waste time and money on an order that may not reach you in time or as expected. While agreements with suppliers provide some degree of assurance that you won’t be left without your goods or money, there are no guarantees. Untrustworthy vendors can compound the issue and may resist giving back your deposit. At the end of all this, your money is still out of your hands and though you can take legal action against, it may or may not solve anything, particularly when the supplier is in another country. Since the LC requires collection of documents to prove that the order is as expected and sent on time before the bank pays out to the supplier, you never have to worry about losing working capital on failed or incomplete orders.
It may come as a surprise that commercial letters of credit are also beneficial to the supplier. When an exporter receives a letter of credit from a customer, he or she is assured of receiving payment for that customer’s order on time and in full. If the supplier ships goods to the buyer and presents negotiable documents to the bank for payment under the letter of credit, the supplier knows that the bank will never release title of the goods to the buyer unless payment is also released to the supplier. Moreover, the supplier is often able to borrow more than 30% of the value of the letter of credit from their bank. So, although the vendor does not receive a deposit directly from the supplier in this instance, they too benefited and protected by the LC.
Letters of credit are designed to facilitate cross-border transactions between buyers and sellers and provide a vehicle to allocate risk between parties. Through this mechanism, both sides can also obtain greater cash flow. Although banks typically require the buyer to block or freeze their cash or credit lines in the amount of the letter of credit, secondary financial institutions can use their own cash or credit lines on behalf of the buyer to avoid this dilemma. Thus, letters of credit can benefit all parties by accommodating each parties risk and cash flows needs.