Finance is undoubtedly not the easiest subject to understand, even for those who’ve been in the industry for years. As a business owner or leader, getting your head around financial tools at your disposal is essential to making sure you have suitable systems and providers in place to accomplish your organisation’s goals.
Large corporations have specialist finance employees, a history and a relationship with their bank, and the know-how and scale to utilise finance to their advantage. Small to medium enterprises (SMEs) often struggle with the same, mostly due to being under-resourced when it comes to personnel, as well as the scale of their operations.
Two financial terms you will come across at some point are bank guarantees and a letter of credit. At first glance, they may appear to be very similar in nature – they are both essentially a guarantee from a bank against risk for a seller that the buyer will pay in full. However, there are critical differences in when and how you would use each product. Let’s take a deeper look at each, as well as the main differences, so you can use them to your SMEs advantage.
What is a Letter of Credit?
A letter of credit is a guarantee from a bank or a non-bank finance provider confirming that a particular buyer will pay their supplier on time and in full. A letter of credit is primarily used in international trade, so your first exposure to the concept will come when you start importing or exporting meaningful sums of product. Of course, when shipping internationally, there is an extensive time where the goods are in transit – the exporter wants to be paid, and the importer wants the goods.
Letters of credit are essential for trade financiers that need certainty that the money they provide your business for the financing agreement will be repaid. The fee to obtain a letter of credit is relatively small, considering the necessity of having one. Usually, the bank or lender that secures the funds will charge a fee of approximately 1%.
There are five main types of letters of credit, including:
- Confirmed. When the buyer’s provider has issued their letter of credit, the seller can have it confirmed with a second bank – think of it as an added layer of certainty.
- Import. This type allows importers to make their payment immediately using a short-term cash advance.
- Export. An export letter confirms with the buyer’s bank that they must pay the seller once all the contract conditions are met.
- Revolving. A revolving letter of credit can cover multiple transactions. It’s often used when the buyer and seller have a longer-lasting business relationship.
- Irrevocable. This type ensures that the buyer is obligated to the seller under all conditions – it cannot be cancelled or altered unless everyone agrees.
What is a Bank Guarantee?
A bank guarantee is a more serious version of a letter of credit – representing a stricter contractual obligation for the bank or similar issuer. The provider will pay the agreed sum of money if one party does not fulfil their side of the contract – insuring either the buyer or seller from losses resulting in the other party not performing their agreed side of the deal. Bank guarantees remove credit risk from the equation and are mostly used in real estate and construction, as opposed to international trade.
The three main types of bank guarantees include:
- Loans. Commonly issued to guarantee the financial obligation in a loan if the borrower defaults on their payments.
- Advanced payments. Acts as a form of collateral, reimbursing advanced payments if the seller does not supply the agreed goods.
- Confirmed payments. Guaranteeing a payment – an agreed amount is paid by the bank to the relevant party on behalf of the client on a specific date.
The Main Differences
There are a few key differences between the two, primarily that letters of credit are better suited for international trade, and bank guarantees are best for government contracts, real estate and construction.
Letters of credit put liability in the hands of the provider, as they collect payment from the client after the transaction. Bank guarantees imply that the bank assumes liability only when the client defaults. Therefore, letters of credit are riskier for the provider, while bank guarantees are riskier for the merchant. It’s this reason that bank guarantees are instead used for significant construction or supply contracts – by providing the guarantee, it communicates that the bidder is financially stable enough to begin and end the contract as proposed.
Both letters of credits and bank guarantees are useful when looking to secure suitable financing. Trade finance providers, both import and export, will often ask for one when finalising a facility. Not only that, but by having a suitable letter of credit in place, alongside sufficient finance, you’ll be in the box seat to negotiate supply purchases without being at the mercy of a big bank.
Keep your business growing with OptiPay. We’re not a bank, and we work with you to secure the right funding for your SME, whether that’s international trade finance or traditional funding facilities. Secure your finance with OptiPay today.