A letter of credit or simply a credit letter is a trading instrument issued by banks to confirm the trade payment terms between buyer and seller.
The letter of credit of LC is required when buyers and sellers operate in different statuary or place large orders that require payment confirmation.
Usually, a letter of credit is required in an international trade deal between importer and exporter.
Both parties can avail of the LC facilities to secure the contract completion. Exporters are usually keen to receive the LCs as they risk the shipment of goods, similarly the importer risks advance payments and a delayed or poor quality of imported goods.
The bank plays the role of a facilitator by issuing the credit letter.
Depending on trade contract terms, the letter of credit may take several forms. The most commonly used LC is irrevocable in nature; however, many applicants use revocable LCs too.
A Revolving Letter of Credit is a bank-issued trade instrument that allows multiple withdraws from a letter of credit facility issued.
A revolving LC allows multiple amounts to withdraw meeting certain conditions and terms as agreed by both parties in the trade contract.
However, unlike other LC facilities, the revolving LC doesn’t require re-approvals from the bank up to a certain time or amount.
How does a Revolving Letter of Credit Works?
Importers and exporters enter the trade contracts through bank guarantees such as LC and LG.
Over time they develop trade relations and require continuous trade deals. Some trade deal orders are shipped in a series of multiple shipments.
The applicant of LC usually gets approved a large amount of LC for the full trade value but wishes to release the payments as it receives shipments.
This is where the revolving credit facility becomes effective for importers and exporters alike.
- The credit amount is renewed or reinstated without specifically changing the LC terms
- The Revolving LC can be termed on time and value of the contract basis
- The applicant can control the payments by adding time or value clauses from the total LC facility
As with any other type of Letter of Credit, a revolving LC can also be revocable or irrevocable. However, the prime utility of the revolving LC is that can be issued on a time or value basis.
Time-Based Revolving Letter of Credit:
The applicant avails the Letter of Credit facility from the bank in full. In a time-based revolving LC, the terms are set for shipments received against a specified time.
The applicant includes the clause of regular payments to the exporter or seller for a series of payments.
Usually, the payments are monthly or quarterly depending on the frequency of the shipments received.
For example, an importer Techno Blue in one country may wish to make regular monthly payments to its seller in another country for the next 12 months.
Let’s say, the total LC facility is $120,000 but the revolving LC facility allows making $10,000 monthly payments.
Cumulative Revolving Letter of Credit:
If the revolving credit facility is cumulative it can adjust the payments of the remaining goods in the following months.
For example, if the buyer receives less than the agreed $ 10,000 inventory, the seller must cover goods shipments in the next months. It allows greater flexibility in the trade deal, but certainly is a risky option for the buyer.
Non-Cumulative Revolving Letter of Credit:
The buyer may wish to reduce the risk by making revolving LC non-cumulative. It bounds the seller to ship the required goods in time with certain terms and conditions.
Any remaining balances due to a shortage of goods supplied cannot be carried over to the next period.
Value-Based Revolving Letter of Credit:
This facility works similarly to that of a Time-based revolving LC. The only difference is the release clause becomes dependent on the value of the goods.
In this facility, the LC payments can only be released if the buyer receives the agreed minimum value of the goods. It bounds the seller or exporter to manufacture on regular basis.
Benefits of Revolving Letter of Credit Facility:
Revolving LC facility is used where the seller and the buyer make regular and consistent trade transactions.
- It saves time and cost to the LC applicant as the facility can be reissued without specific changes
- It can facilitate regular and consistent trade from a regular supplier
- It offers flexibility and trust between the buyer and seller
- It motivates the sellers to manufacture of consistent levels if the buyers opt for non-cumulative revolving LC
Limitations of Revolving Letter of Credit Facility:
Apparently, the revolving LC provides great flexibility to both buyers and suppliers. In practice it is used widely due to the changing nature of trade contracts and customs regulations.
- Revolving LC facility works well with the regular and consistent supplier only
- It cannot be used with a one-time trade agreement
- Frequent changes in Customs, taxes such as VAT, and product designs require frequent amendments in the trade deals, hence payments through LCs