Why do purchase order financiers pay foreign suppliers with a letter of credit (LC)?

Why do purchase order financiers pay foreign suppliers with a letter of credit (LC)?

Image credit: Stuart Hill

Most purchase order financing clients are importers who buy goods from another country and sell them to companies in Australia or New Zealand.

A number of businesses will usually request that the financier prepay their supplier by direct bank transfer however, this carries significant problems depending on the size of the transaction.

While providers of purchase order finance can pay foreign suppliers with a letter of credit, documentary collections or direct transfer, they will only prepay a foreign supplier with a letter of credit.

Why is this?

First, let’s go over each payment method very quickly.

*These are broad overviews:

Letter of credit: A bank instrument, an issued document that guarantees payment, provided specific conditions are met.

Documentary collection: A bank-intermediated process where shipping/export documents are exchanged for the release of payment once conditions are met.

Direct bank transfer: A transfer of funds from one bank to another. This is the most common form of transfers for low dollar value transactions.

Let’s start with the first questions always asked – why can’t a prepayment to an overseas supplier be made by direct bank transfer?

Simply put, there is no assurances or controls in place that the product/s will be delivered. Once the payment has been made, the buyer (client) has next to nothing – if any – recourse if things go wrong and supplier won’t remedy the problem of failure to supply.

From the financier’s point of view, making a prepayment by direct bank transfer is the same as extending an unsecured loan to the supplier.

A purchase order financing provider offers to finance you – not to your supplier not to mention the extreme cost if the financier had to recover lost funds from a foreign company.

In principle, a documentary collection could be used as a form of prepayment.

Although it’s safer and more secure than a direct bank transfer, it still does not offer the layer of protection that a letter of credit can fix. Most financiers won’t use them for prepayment unless you (the client) are a stronger credit and can rely on you taking the risk or that if something goes terribly wrong the financier can comfortably collect losses directly from you.

The safest way to prepay a supplier is with a carefully strutured letter of credit, which specifies the appropriate specifications, inspections, and delivery schedules.

The reality is, no payment tool is 100% safe, a letter of credit offers many protections to the buyer (and their purchase order finance company).

If you’d like to hear war stories about (many) clients being saved by putting a letter of credit in place, reach out to the Stak team.

 

See if Stak can help with your supplier payments.

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We regularly share our thoughts on trade finance, lending, company culture, product strategy and design.

Stak works with clients that sell to some of the largest buyers in Australia & overseas.

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