- the invoice
- the transport document
- the insurance document
- anything else the credit names
Each one against the exact terms of the credit.
Net Worth & Solvency Glossary · Lending
Letter of Credit (LC) and the Trade Finance Net Worth Test
noun · full form of "LC" in banking and payment terms · also called a documentary credit
Definition
A letter of credit (LC) is a bank's written undertaking to pay a seller a stated amount when the seller presents documents that match the terms of the credit.
The bank pays against documents, not against the goods. LC is the full form used in banking and payment terms.
- Searched as
- LC payment
- LC in payment terms
- LC at sight
Who is who in a credit
- AApplicantThe buyer. Asks its bank to open the credit in the seller's favour.
- IIssuing bankThe buyer's bank. Undertakes to pay when the documents match the credit.
- BBeneficiaryThe seller. Ships, then presents the documents the credit names.
- VAdvising bankThe seller's bank. Passes the credit to the seller and forwards the documents.
Payment runs on the documents. Nobody at the bank looks at the goods.
What it pays against
01What an LC undertakes to pay against
A buyer (the applicant) asks its bank to open a credit in favour of a seller (the beneficiary). The bank pays when the documents presented match the credit exactly. These are typically the invoice, the transport document, the insurance document and anything else the credit names. The bank does not inspect the shipment and does not judge whether the goods arrived in good order.
How a credit moves between the four parties
Four-party flowGoods ship from the seller to the buyer, outside the credit
- asks its bank to open a credit
- opens the credit
- advises the credit to the seller
- The buyerApplicant
- The buyer's bankIssuing bank
- The seller's bankAdvising bank
- The sellerBeneficiary
Documents presented by the seller, forwarded by its bank, checked by the issuing bank against the credit
Payment from the issuing bank, through the advising bank, to the seller, once the documents match
Documents move towards the issuing bankPayment moves towards the sellerThe goods take their own route
- inspect the shipment
- judge whether the goods arrived in good order
A credit pays against paper, which is what lets two parties who have never met trade on it.
A small discrepancy can hold up payment
This is what makes an LC workable between parties who have never met. It is also why a small discrepancy, such as a misspelt consignee name, can hold up payment.
- "LC payment" or "LC in payment terms"
- When people search for these, they mean this arrangement: the seller is paid by a bank through the credit, not directly by the buyer on open account.
- "LC at sight"
- An LC at sight pays as soon as compliant documents are presented. A credit that pays after a stated period is a usance LC, described in section 03.
On a certified position
02How LC limits appear in a borrower's certified liability position
An LC creates exposure from the day the credit is opened, because the bank has committed to pay on presentation. How it shows in a certified position depends on where it stands on the certificate date.
-
State on the certificate dateCredit open, no bill accepted
The borrower's obligation has not yet crystallised.
Where it showsDisclosed beneath the figureas a contingent liability, not deducted from it -
State on the certificate dateBill accepted under the credit
The borrower now owes the amount.
Where it showsEnters the computationas a firm liability -
State on the certificate dateSanctioned limit
The ceiling the bank has agreed, not an amount owed.
Where it showsStated, not deductedthe limit is reported alongside, never as a debt
What a certificate for a borrower with LC limits states
- 1The sanctioned limit
- 2The amount outstanding under it
- 3Whether any bill has been accepted
The ceiling is treated as if it were all owed.
The bank's open commitment on the undrawn part disappears.
Trade facilities move quickly, so the certificate names the date it speaks to, and balances are confirmed with the bank rather than taken from the borrower's ledger. This is the position a CA reads when preparing a net worth certificate for a bank loan.
Sight, usance, UCP
03Sight and usance LCs, UCP rules and Indian import documentation
Indian import practice runs mostly on two forms.
Pays when compliant documents are presented
- Documents presented
- Paidon presentation
The seller is paid as soon as the documents match the credit.
Pays after a stated period
- Documents presented
- Stated periodthe buyer is financed for this time
- Paidat the end of the period
This finances the buyer for that time, and the obligation shows in the books as an acceptance.
One standard for every discrepancy
Most cross-border credits are issued subject to the uniform customs and practice rules for documentary credits that banks worldwide apply. A discrepancy is therefore judged against a common standard, not local usage.
At the bank's counter
- 1Margin and a charge
The opening bank usually asks for margin and a charge over the goods or the documents.
- 2Amendments need everyone
Amending a credit needs every party's agreement, so a change requested after shipment is slow and sometimes impossible.
- 3Import papers must match
Banks expect the underlying import documents to match the credit, and a mismatch between the bill of entry and the invoice is a common cause of delay at the counter.
LC vs bank guarantee
04Where an LC parts company with a bank guarantee
The difference lies in whether payment is expected.
A payment mechanism
Everyone involved expects it to be used. The seller ships expecting to present documents and be paid.
So the business isfinancing its trade
A safety net
Nobody expects to invoke it, and invoking it means something has gone wrong.
So the business isgiving assurance
That is why the same bank documents, prices and secures the two differently even when the amounts match. A business that regularly uses LCs is financing its trade. A business holding guarantees is giving assurance. Lenders assess the two activities differently.
Written by Subham Jhunjhunwala · Reviewed by CA Sundram Gupta
This entry describes Indian practice in general terms and is not advice on a particular facility.
Need help with a certificate that uses a letter of credit? See our Net Worth Certificate for Bank Loan.