If you’re in the business of importing and exporting, buying and selling, a revolving letter of credit can smooth transactions for you. Your work is likely full of some risky situations. For example, how does an exporter know that their buyers will make good on their promise to pay?
A revolving letter of credit can help. When it’s in place, it can allow buyers and sellers to be more confident in their business arrangements. It can help by ensuring that payments are made on time.
It sounds like a win-win, doesn’t it? Here, we’ll look at the specifics of revolving letters of credit. We’ll dive into:
• What is a revolving letter of credit
• How a revolving letter of credit works
• The different types of revolving letters of credit
• Limitations of revolving letters of credit
• The pros and cons of a revolving letter of credit
What Is a Revolving Letter of Credit?
When you hear the phrase “revolving credit,” it may sound familiar from personal finance tools you’ve used, such as credit cards and equity lines of credits. These revolving credit accounts have a credit limit, which represents the maximum amount that an individual or business can spend. The individual or company can draw on the account up to the limit. Then, as they pay back the amount they owe, the amount of credit will rise back to its original value.
A balance can be paid off in full at the end of a billing cycle, or an individual may choose to carry it over into the next month, otherwise known as “revolving” the balance.
A revolving letter of credit is a bit less common, and they don’t function in exactly the same way. In fact, you can think of them as a tool for your business. They are specifically used to facilitate the regular shipments of goods or the delivery of services between buyers and sellers. They are most common in international trade, in which the buyer and seller are operating in two different places and/or regulatory environments.
Recommended: What is a Credit Card and How Does it Work?
How Does a Revolving Letter of Credit Work?
So now that you have a general idea of what a revolving letter of credit is, let’s look into how it works. The revolving line of credit is typically only issued once for a given period of time. This prevents buyers and sellers from needing to open a new line of credit every time they wish to make a transaction, which is very convenient.
The letter of credit is a guarantee from the buyer’s bank that payment will be made once the exporter ships the ordered goods and presents documentation as proof.
Because letters of credit tend to be labor-intensive and relatively expensive, they may only be recommended in higher-risk situations. “Such as?” you ask. Here’s an example:
You might get one of these letters of credit when dealing with a new trade relation or when extended payment terms are requested.
In order to receive a revolving letter of credit, having good credit is important. In fact, you may be limited if you have bad credit. If you have poor credit, there are ways you can build your credit which may be worth pursuing.
Start by checking your credit scores, and monitoring your scores regularly to ensure there are no mistakes on your credit report. Be aware that credit scores may be different at each of the three major credit reporting bureaus (Equifax, Experian, and TransUnion), and your credit score is updated regularly. A couple of cornerstones of a good credit score: Always make bill payments on time, and pay down debts.
Recommended: What is Considered a Bad Credit Score Range?
Now that you know how a revolving letter of credit works, let’s move ahead. Next, let’s consider the steps required when applying for a letter of credit, as well as how the transaction facilitated by the letter works:
1. The importer and exporter complete a sales agreement, and the importer applies to their bank for a letter of credit.
2. The importer’s bank drafts the letter of credit, and the exporter’s bank approves it and sends it to the exporter.
3. The exporter ships the goods the importer has agreed to buy and sends documentation to their own bank.
4. The exporter’s bank checks over these documents to make sure they are correct. If they are, the exporter’s bank submits the documents to the importer’s bank.
5. The importer’s bank then sends payment to the exporter’s bank, and the importer can claim the goods.
With a revolving letter of credit, steps three through five can happen over and over again in a given period of time, without a new letter of credit being drawn up.
Types of Revolving Letters of Credit
There isn’t just one template for revolving letters of credit. There are a variety of ways they can be written, in order to best suit a person’s or a business’ needs. Revolving letters of credit can be subdivided into two main categories, one based on value and the other based on time.
Time-Based Revolving Letter of Credit
Some revolving letters of credit are based on time. This means a specific payment amount can be drawn down over a set time period. For example, an importer could have a revolving letter of credit worth $120,000 drawn to cover a six-month period. During that time, payments of $20,000 could be made to an exporter each month. At the end of the six-month period, the revolving letter of credit expires.
Cumulative Revolving Letter of Credit
The time-based resolving letter of credit can be subdivided again into two different subcategories: cumulative and non-cumulative revolving letters of credit. If the revolving letter of credit is cumulative, then previously unused limits can be shifted ahead and used in subsequent time periods. In the example above, if the exporter doesn’t ship any goods in the second month, then it could ship $40,000 worth of goods in month three.
This type of set-up provides the seller with a certain amount of flexibility. However, it can be riskier for the buyer who isn’t receiving goods regularly.
Non-Cumulative Revolving Letter of Credit
The other sort of time-based revolving letter of credit is non-cumulative. This means that previous unused amounts of credit cannot be rolled over into a subsequent month. So, if the exporter in the example above doesn’t ship any goods in the second month, only $20,000 worth of goods can be shipped in each of the subsequent months.
This set-up is less risky for the buyer, because it locks the seller into shipping goods within a narrower time period and under more specific conditions. If the seller doesn’t supply the promised goods within a certain period, they cannot carry that over into a subsequent period.
Value-Based Revolving Letter of Credit
Now, for the other main variety: The value-based revolving letter of credit is much like its time-based counterpart. The biggest difference is payment from the buyer is only released when they receive goods worth a certain value.
Say, for example, a revolving letter of credit is issued for $120,000 over six months for goods worth $20,000 each month. The exporter can only ship and receive payment for goods worth $20,000 each month. If, for example, they are only able to produce $15,000 worth of goods in one month, they cannot ship the goods to the seller, and the seller won’t provide payment. In this case, the value is very specific, and it really matters.
Advantages of Revolving Letters of Credit
So why issue a letter of revolving credit? There are a number of benefits. Here are some of the most important ways it can help you run your business:
• It saves time and money.
• Because it is revolving, the letter of credit does not need to be reissued for each transaction during a set period.
• It helps facilitate regular trade between a buyer and a seller and can help keep your bank account healthy.
• It can help build trust between buyers and sellers.
• It can incentivize sellers to manufacture a consistent level of goods, especially for non-cumulative and value-based letters.
• It can provide flexibility in terms of the types of agreements buyers and sellers can enter into.
Disadvantages of a Revolving Letter of Credit
Despite the advantages listed above, there are some limitations and drawbacks to consider:
• Letters of credit tend to be limited to one supplier only.
• They don’t apply to one-time transactions.
• Changes, such as changes to tax law, customs rules, or product design may require amendments to the agreement.
• Bank fees may make revolving letters of credit costly, especially for applicants.
The Takeaway
If you run an importing business and you’re buying goods from overseas — especially from an exporter that represents a new business relationship — a revolving letter of credit can make things easier. It can remove some of the risk of the transactions as you build trust with this new supplier. Of course, if you’re an exporter, the same applies.
That said, it’s important to consider the limitations of using a letter of credit, in particular the cost, and weigh that against the benefits. No two people or businesses have the same financial situations and needs, so exploring how these letters of credit might fit with your goals is vital.
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FAQ
When should a revolving letter of credit be used?
You may want to consider using a revolving letter of credit to minimize risk when engaged in importing and exporting or certain other kinds of buying and selling. It’s especially useful when a relationship with a seller is new or you wish to have more control over how many goods you’re buying over a set period of time.
Who issues the revolving letter of credit?
The revolving letter of credit is issued by the buyer’s bank.
What is an irrevocable revolving letter of credit?
An irrevocable revolving letter of credit cannot be changed unless all parties involved agree to the modifications of the contract.
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