When buyer and seller are located in different countries, trust is not always enough. A documentary credit allows a bank to intervene in the transaction and make payment conditional upon the accurate presentation of the agreed-upon documents.
Selling or buying goods in another country involves risks that don't always arise in a domestic transaction. Distance, legal differences, transportation, and the difficulty of collecting a debt abroad can turn a profitable transaction into a collection problem.
credit (also known as letter of credit)is one of the most widely used instruments to strengthen security in international trade.
Its operation is based on a simple idea. The bank commits to making payment when the exporter presents, within the established timeframe and under the agreed conditions, the documentation required by the letter of credit. It does not, in itself, guarantee that the goods are perfect. What it guarantees is that payment will be made if the documents submitted strictly comply with the agreement.
What is a documentary credit?
A documentary credit is a payment order issued by the importer's bank in favor of the exporter. The importer requests their financial institution to open the credit and specifies the conditions that the foreign supplier must meet. The bank will notify the exporter of the transaction, usually through a branch in their country. Once the goods have been shipped, the exporter presents the required documents. If they are complete and free of discrepancies, the bank will proceed with payment according to the agreed terms.
The bank thus assumes a central role. The exporter is not solely dependent on the client's willingness to pay, and the importer knows that payment will only be made upon documentary proof of proper shipment.
How does the operation unfold?
The first step is for the buyer and seller to agree on the terms of the international sale. They must determine the price, the goods, the delivery schedule, the shipping method, the delivery location, the insurance, and the necessary documentation to prove compliance.
Next, the importer requests their bank to open a documentary credit in favor of the exporter. The bank analyzes the risk of the transaction and, if it approves it, issues the credit. A bank in the exporter's country notifies the beneficiary of the opening and its terms.
The exporter checks the contents and, if they match the agreement, proceeds to ship the goods. Then, they submit the required documentation to their bank.
If the documents are in order, the payment is processed and sent to the importer's bank so that they can have the merchandise available.
The documentation determines the charge
In these types of transactions, documentation is not a simple administrative formality. It is the key that unlocks payment. Among the most common documents are the commercial invoice, bill of lading, packing list, certificate of origin, insurance policy, health certificates, and inspection documents.
The loan agreement must specify precisely what documents are required, who must issue them, what information they must contain, and within what timeframe they must be submitted.
An incorrect date, a description that does not match literally, or a missing signature can create a document discrepancy and delay or prevent payment.
Physical inspection protects the importer
The bank checks the documents, but does not open containers or verify the actual quality of the goods. For this reason, the importer may require a physical inspection certificate issued before shipment. The inspection can be carried out by the buyer, a trusted individual, or an independent, specialized company.
This certificate allows you to verify aspects such as the quantity, condition, quality, packaging or technical characteristics of the product.
In high-value transactions or those involving sensitive goods, including a pre-inspection can prevent problems that are difficult to resolve once the shipment has already arrived in the destination country.
Revocable and irrevocable credits
A revocable credit can be modified or cancelled before payment without the beneficiary's consent. This type of credit offers very little security to the exporter and, in practice, has limited use.
In contrast, an irrevocable credit cannot be unilaterally canceled or modified once issued. Any changes will require the consent of all affected parties.
Therefore, irrevocable credit is the usual option when the aim is to provide a real guarantee of payment to the foreign supplier.
Confirmed and unconfirmed credits
In an unconfirmed letter of credit, the primary payment obligation rests with the issuing bank, which is usually the importer's bank. The advising bank informs the exporter of the opening of the letter of credit and may handle the paperwork, but does not necessarily provide its own payment guarantee.
In a confirmed credit, another banking entity incorporates its commitment into that of the issuing bank.
This confirmation can be especially useful when there are doubts about the solvency of the issuing entity, the stability of the buyer's country, or the possibility of transferring funds abroad.
Payment on demand or on credit
In a sight credit, the exporter receives payment once they present compliant documents and the bank completes its review. In a term credit, payment is made at a later date. The maturity date can be calculated from the shipment date, the presentation of the documents, or any other agreed-upon date.
This second option allows the importer to obtain a period of commercial financing, while the exporter can explore the possibility of receiving payment in advance through their financial institution.
Divisible credits and open lines
A divisible credit line allows for partial disbursements as different shipments are made. This option is useful when goods are delivered in batches or in stages. Revolving credit lines or open lines of credit can also be established, which are renewed within a limit and for a specified period.
These structures facilitate ongoing business relationships, although they require rigorous control of the amounts used, due dates, and documentation corresponding to each shipment.
Transferable credits and transactions with intermediaries
A transferable credit allows the initial beneficiary to request that all or part of its amount be made available to another beneficiary. It is typically used when the exporter acts as an intermediary and needs to pay one or more suppliers. For this option to exist, the credit must explicitly state this; an informal agreement between the parties is insufficient.
Another structure used by intermediaries is the back-to-back. In this structure, the beneficiary of an initial loan uses that guarantee to open a second loan in favor of their supplier.
Advance loans and revolving loans
Some loans allow the exporter to receive a portion of the funds before submitting all the required documentation. In loans with a red clause, the advance can be issued against a receipt or a specific guarantee. When a green clause is in place, the beneficiary must also provide proof of the availability or storage of the goods.
Revolving credit lines allow you to reuse the funds over a period of time, according to the established terms and conditions. They are common in recurring business relationships where several similar shipments are made.
What commissions can it generate?
Documentary credits offer security, but their cost is higher than that of a standard bank transfer. The importer may have to pay opening, processing, risk, modification, and deferred payment fees. The exporter, on the other hand, may incur costs for notification, confirmation, negotiation, transfer, or document review. Discrepancy fees may also apply when the documents presented do not match the terms of the credit.
The parties can negotiate who assumes each expense, although this division must be clearly reflected.
Advantages for the exporter
The main advantage is payment security. When the credit is irrevocable and, where applicable, confirmed, the exporter has the commitment of one or more banks. They also know when they will receive payment and can use the credit to secure financing for manufacturing or purchasing the goods. Furthermore, it reduces their direct exposure to the buyer's creditworthiness, provided they strictly comply with the documentation requirements.
Advantages for the importer
The importer doesn't simply pay based on a promise from the supplier. Payment is contingent upon the presentation of documents proving shipment in accordance with the established terms. Credit also strengthens the importer's image of solvency with international suppliers and can facilitate access to markets where a consolidated business relationship doesn't yet exist. However, for this protection to be effective, the required documents must allow for verification of the essential aspects of the transaction.
Main drawbacks
A documentary credit requires coordination between the company, the bank, the carrier, the insurer, and sometimes the inspection agency. Its processing can be slow if the conditions are complex or if discrepancies arise.
For the exporter, the main risk is preparing the documents incorrectly. For the importer, it's paying against compliant documentation and then discovering that the goods do not materially meet their expectations.
In addition, there is a higher bank fee than other means of payment.
Despite these limitations, it remains a particularly useful tool in high-value transactions, with new clients, or in countries that present a higher risk.
An example
A Spanish distribution company buys 5,000 bottles of olive oil from an Italian supplier for €48,750 (€9.75 per bottle). As this is the first time the two companies have done business together, they agree that payment will be made via an irrevocable and confirmed letter of credit. The buyer's bank commits to paying the €48,750 only when the supplier presents the agreed-upon documentation, including:
- Commercial invoice.
- Bill of lading (CMR).
- Certificate of origin.
- Transport policy.
- Health certificate.
The supplier ships the goods and submits all the required documentation. After verifying that there are no discrepancies, the bank makes the payment to the exporter. The Spanish company incurs approximately €620 in bank charges for opening and managing the letter of credit, while the exporter pays €280 for notification and confirmation fees.
Thanks to documentary credit, the seller has the guarantee of payment and the buyer knows that payment will only be made when it has been documented that the goods have been shipped under the agreed conditions.
A simple error in the documentation (for example, an incorrect date or a different description of the goods) can delay payment until the issue is resolved.
How our firm can help you
Our team can assist your company before finalizing an international sale. We review the contract, payment terms, required documents, deadlines, and the allocation of bank fees.
We also analyze the terms of the documentary credit before the exporter ships the goods or the importer authorizes its opening. When discrepancies arise, we review the documentation and explore possible alternatives to avoid delays, rejections, or financial losses.
In international trade, a documentation issue can hold up a transaction worth thousands of euros. Reviewing the letter of credit before issuing or accepting it is usually much less costly than trying to resolve the problem after shipment.
You can contact this professional office for any questions or clarifications you may have.
Warm regards,
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A Àmbit Assessor, SL has 40 years dedicated to the tax, comptable and labor consultancy of the Pime.
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