Full Form of LC

The full form of LC is a Letter of credit. A letter of creditLetter Of CreditA Letter of Credit (LC) is issued by a buyer’s bank to ensure timely, full payment to the seller. If the buyers default, the bank pays the sellers on their behalf.read more is used mostly in international transactions where the document the buyer’s bank gives, known as the issuing bank, guarantees that the buyer will pay the seller the correct amount. If the buyer fails to pay the amount to the seller, the bank must pay the outstanding dues on the buyer’s behalf.

Features

The features of the letter of credit are as follows –

  • Revocability – The letter of credit can be revocable or irrevocable. Mostly the irrevocable LC is prevalent as it cannot be modified with all parties’ permission times, whereas if a bank issues Revocable LC, then such a bank has the authority to revoke that LC issued at any time.Negotiability – The LC is considered an easily negotiable instrument and can be used as money as it can be passed on easily from one party to another. But, LC is negotiable if issued as an unconditional promise to pay the amount on demand at a given time.

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Types

The different types of the letter of credit are as follows:

  • Irrevocable LC – This type of LC cannot be modified or canceled without the beneficiary’s prior approval.Revocable LC – This type of LC can be modified or canceled by the issuing bank without beneficiary permission.Transferable LC – This type of LC is allowed to be transferred by the seller to other parties and acts as money.

How does it Work?

  • The buyer must approach the bank in his home country for its issuance and provide various information such as payment amount, date of shipping of goods, mode of shipment, arrival time and place of shipment, details of the seller, etc., to get the letter of credit.After getting the details and if found satisfactory, the bank will issue the LC, which is the promise to send the money to the seller, and then the bank will send the same to the seller’s bank, generally located in the home country of the seller.After receiving the LC, the seller’s bank will verify it and forward it to the seller. Then, the seller has to verify that all the terms and conditions listed in LC match the agreed one with the buyer. Now, to receive the payment by the mode of LC, the seller has to satisfy all the LCs requirements.If all the conditions meet and the delivered goods are as specified, the seller will get the payment within the time mentioned in the LC.

Example of LC

Mr. Edward, a clothes business named Textile Incorporation located in the USA, received an order of clothes worth $20,000 from a company named Clothing Incorporation located in London. The clothing incorporation was new to Mr. Edward, so he demanded a letter of credit. So, the buyer asked the local bank to issue the LC to the seller bank, which is an instrument that is a guarantee given by the buyer’s bank, which says that if the buyer fails to repay the number of dues, then the issuing bank will pay on behalf of the buyer.

Elements

The elements of the Letter of credit are as follows:

  • Applicant – The applicant is the purchaser of goods or the receiver of the services in any business transactionAny Business TransactionA business transaction is the exchange of goods or services for cash with third parties (such as customers, vendors, etc.). The goods involved have monetary and tangible economic value, which may be recorded and presented in the company’s financial statements.read more.Beneficiary – The beneficiary is the one who sells the goods and services and is the recipient of the amount in a business transaction. The beneficiary will provide all the documents to process the letter of credit.Issuing Bank – The issuing bank is the bank that issues a letter of credit upon receiving the parties’ satisfactory documents. If the applicant fails to pay the money to the beneficiary, the issuing bank must pay on the applicant’s behalf.Advising Bank – The advising bank is the bank that advises the beneficiary about the use and advantage of the letter of credit. The bank is responsible for sending the required documents to the issuing bank and has no obligation to clear the dues if the issuing bank fails to retire its obligations.Confirming Bank – The confirming bank has to confirm the LC and assumes obligations similar to that of the issuing bank. It also evaluates the country and the bank that issues LC before confirming the LC.

Importance

  • LC helps do trustworthy business worldwide by reducing the risk of bad debtsBad DebtsBad Debts can be described as unforeseen loss incurred by a business organization on account of non-fulfillment of agreed terms and conditions on account of sale of goods or services or repayment of any loan or other obligation.read more.LC can even help a person get pre-shipment finances from financial institutionsFinancial InstitutionsFinancial institutions refer to those organizations which provide business services and products related to financial or monetary transactions to their clients. Some of these are banks, NBFCs, investment companies, brokerage firms, insurance companies and trust corporations. read more and banks.

Advantages

  • When the LC is issued, there is a high chance that the money may be received on time by the seller. Thereby reducing the risk to the seller.One can easily sort out any discrepancy or dispute following the banking regulations that apply to issuing LC.

Disadvantages

  • The cost of taking a letter of credit is comparatively higher. It consumes more time as it requires many formalities.LC ignores currency fluctuation as it does not consider the difference in the rate between the date of contract/sale and the date of payment.

Conclusion

Thus, a Letter of Credit (LC) is required to have international transactions smoothly. One should understand the regulations and formalities well before making any commitments. A Letter of Credit helps to improve business transactions worldwide as it reduces the risk of non-payment of dues. Thus, the seller mostly demands a Letter of Credit these days while exporting their goods.

This article is a guide to the Full Form of LC, i.e. (Letter of Credit). Here, we discuss how LC works, its types, features, examples, advantages, and limitations. You may refer to the following articles to learn more about finance: –

  • Bank CreditLetter of GuaranteeCredit FacilityCredit Enhancement