Plain definition
A letter of credit, or LC, is a bank’s undertaking to pay the beneficiary when the documents presented comply with the credit’s stated terms. It is documentary: the bank examines the documents required by the LC. It is also independent from the underlying sales contract, so a commercial dispute does not automatically change the documentary test.
An LC can support a supplier who needs confidence before shipping, but it is not a guarantee that the goods are suitable or that the documents are free of commercial risk. The applicant may need a facility, cash margin, fees, and an indemnity to the issuing bank. The exact obligations depend on the LC wording and governing rules.
Illustrative example
Monetary examples use Saudi riyals (SAR). The same principles apply in other currencies.
Suppose a Saudi distributor orders equipment for from an overseas supplier. The supplier will ship only if a bank issues an LC requiring a commercial invoice, packing list, and bill of lading by 30 September. The distributor’s bank issues the LC after taking a cash margin and using the remaining exposure under a trade-finance facility.
The supplier presents documents on 28 September. If they comply, the bank pays under the LC and the distributor must reimburse the bank under its arrangement. If the bill of lading instead shows shipment on 2 October, after the latest allowed date, the discrepancy must be handled under the LC process; ignoring it can delay payment, goods release, or both.
A letter of credit is not the same as a bank guarantee. The LC is primarily a documentary payment undertaking; a guarantee supports performance or payment under an underlying obligation.
Why it matters
A founder can confuse an LC with an ordinary purchase order and overlook the bank limit, cash margin, document deadlines, and reimbursement risk. That can turn a planned shipment into an unexpected liquidity squeeze or a dispute at the border.
Practical consequence
Before issuing an LC, map the contract terms to the documents the supplier can realistically produce, the latest shipment and presentation dates, the facility limit, fees, cash margin, and reimbursement date. Assign one person to check draft documents before shipment.
Add the cash margin and reimbursement timing to the cash forecast. Escalate any discrepancy before expiry, and obtain trade-finance or legal advice when the contract, LC wording, or claim position is unclear.