CASE 1 : Letters of Credit are too Expensive!

Letters of Credit are too Expensive !!!

This was what a Buyer from an Irish Exporting company stated when he convinced the Exporter to sell to them on open account terms. The  Buyer obtained 60 days credit, which was to be calculated from the date of the invoice. The value of the order was USD 100, 000 and the goods were despatched and invoiced by the Irish Exporter on the 15th April 2006.

The payment  was due on the 14th June 2006. The payment eventually arrived on the 21st August 2006, over two months late. The delay in payment cost the Exporter USD 1700 as it resulted in his account being overdrawn by this amount for 68 days at 9% per annum.

So are Letters of Credit too Expensive ???

The Irish Exporter could have insisted on receiving a confirmed Letter of Credit.

The following costs would have applied at that time:

Confirmation Fee USD $250
Acceptance Commission (@ 1.5% pa for 60 days) USD $250
Negotiation / Payment Fee USD $150
Out of Pocket Expenses (estimate) USD $60
Total Letter of Credit Cost USD $710
Interest Cost as a result of late payment USD ($1700)
Benefit of using Letter of Credit USD $990

The Letter of Credit looks expensive because the costs are very visible and are linked to each transaction. The benefits, on the other hand, are intangible.

What benefit would the confirmed Letter of Credit have provided to the Exporter?

A Guarantee of payment on the due date from the confirmation bank. (Provided the terms and conditions of the Letter of Credit were complied with).

No risk of non-payment as a result of problems with the buyer or the Asian economy.

A definitive date for the receipt of funds, particularly important for devising proper currency hedging strategies.

The opportunity to receive the payment in advance of the due date through non-recourse discounting of the receivable.

Please note that this case has not accounted for the costs the Irish Exporter incurred in chasing the debt with the buyer. In addition if the Exporter had sold his foreign currency receivable on a forward basis to his bank for the original due date, they may have incurred a further cost in cancelling or rearranging the forward contract.

Letters of Credit although appearing expensive do provide real and tangible benefits to companies. In this case the Irish exporter only lost US$ 1700. Of course if the buyer had not paid at all they would have lost the whole US$ 100,000.

Source : http://www.aibtradefinance.com/tf/CaseStudy_1.asp

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