A Better Alternative to Letters of Credit

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What is a Letter of Credit?

Letters of credit have been around almost as long as commercial trade itself. A letter of credit is a guarantee from the buyer’s bank that states the payment of a buyer’s obligation will be received on time and in the correct amount. Letters of credit take many forms; a standby letter of credit is used for multiple transactions while a commercial letter of credit is used for just one.

Typically, a business will require a letter of credit from a buyer when they're unsure of the risk; specifically, if the buyer is perceived to have a higher risk of non-payment because they are new to the business, and/or if the buyer is foreign.

A commercial letter of credit cost is up to 3% of the total transaction amount, with other letters of credit fees included. 

What Are the Drawbacks to Letters of Credit?

In today’s digital world, letters of credit can be a cumbersome, expensive, and time-consuming tool for facilitating a transaction. More importantly, letters of credit place a burden on buyers at a time when they want a transaction to go as smoothly and as quickly as possible.

Consider the following issues buyers often face with letters of credit:

  • It is up to the buyer, not the seller, to obtain and pay for any letters of credit.
  • For commercial letters of credit, buyers must obtain a letter from their banks for every shipment.
  • Letters of credit can tie up the buyer’s lines of credit with its bank, reducing their financial flexibility.
  • Even the smallest errors or problems with a letter of credit can cause a bank involved to refuse to issue payment once the shipment arrives.
  • The claims process can be lengthy and laborious and can be derailed by minor discrepancies in paperwork.

Because of these drawbacks, buyers may resist using letters of credit, especially if they are used to dealing with open account terms that allow payment after they have received a shipment.

Fortunately, there are alternatives to letters of credit—such as trade credit insurance—that offer a more convenient and inexpensive option to streamline a transaction. 

The Credit Insurance Alternative

Trade credit insurance offers a similar guarantee of payment as a letter of credit, but without the added costs and burdens. This solution is unlike letters of credit because it’s not just one transaction through a bank, it’s a continued partnership. Credit insurance allows businesses to protect themselves from non-payment, as well as drive growth and effectively manage risk. 

The cost of trade credit insurance is generally cheaper than a letter of credit and can often pay for itself with the additional sales that are generated from offering more favorable payment terms. You can incorporate the cost of credit insurance into the cost of their goods. Simply increasing a product cost by 0.10% can be enough to ensure protection while the cost remains neutral for the buyers. The increased sales volume from open terms as opposed to letters of credit typically offsets the small increase in the margin.

Check out our Guide to Trade Credit Insurance today!

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What Are the Advantages of Trade Credit Insurance?

Trade credit insurance can remove burdens from buyers and simplify transactions. Businesses that choose credit insurance as a source of finance also benefit from safe sales expansion—domestically and abroad—to new and existing buyers. Transactions are quick and simple. You won’t have to rely on the buyer handling the burden of obtaining a letter of credit from their bank. Rather, you will know they are covered for the sale before the transaction even takes place. And when the unexpected bad debt loss does occur, the business can be confident they’ll be paid.

Using trade credit insurance, you can:

  • Create the means for easy payment that does not impact buyers’ access to credit.
  • Offer open terms and more aggressive credit limits to your customers.
  • Eliminate the need for invoices or shipping documents, unless a buyer defaults on payment.
  • Ensure that payment is based solely on compliance with the contract of sale.
  • Pursue safe sales expansion and gain access to more working capital to recapture the cost of credit insurance.
  • Gain access to more working capital by giving their lender additional comfort in one of their largest assets: their accounts receivable.

Additionally, it’s considerably cheaper than letters of credit, with the cost being absorbed into a smoother transaction rather than presented to the buyer at an additional cost. Credit insurance is an everyday partnership, rather than a one-time transaction with a bank.

Euler Hermes provides credit protection and market insights with risk analysts evaluating current and potential buyers behind the scenes, every day. Our priority is predictive protection.

Why is Trade Credit Insurance a Better Alternative?

As a business, you want to grow. With trade credit insurance, you can grow with confidence.

With a letter of credit, your ability to grow may be reduced by requiring letters of credit, especially if your competitors are offering open terms with the use of trade credit insurance as a source of finance.

Call us today to learn how we can protect your business from loss, help you grow, and predict the changing risks of your current and potential buyers. Let’s take control of tomorrow, together.

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