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By A.Noton
The letter of credit – factoring options are two different kinds of trade financing alternatives available to businesses. The former relies on a bank. The latter relies on a financing party that is not a bank. Of the two, the latter is easier to obtain during difficult economic times than the former.
Suppliers routinely get paid with this financing method in national and international transactions. Essentially, this is a document provided by a bank that guarantees payment to the seller. Should the buyer be unable to make payment, the bank will cover the payment in full or the remaining purchase amount.
The document is a financial instrument that has a dual purpose. It ensures the suppliers get paid and that the buyer receives the goods. It protects both parties in the transaction. This device has a variety of forms. The most common are the revocable, irrevocable, standby, transferable and qualifying types of this instrument.
The revocable form permits the issuer to modify, amend or cancel it. This is not favored by suppliers as it increases their risk. The irrevocable type does not permit amendments, modifications or cancellation without an agreement between the parties. Suppliers favor it as it guarantees payment.
A standby is a payment guarantee and not in effect a payment mechanism. Under the agreement, the supplier may draw on this guarantee should there be payment failure. Transferable letters can be either revocable or irrevocable. They allow for the transference of part or all of its benefit by the recipient to another party.
Qualifying for this form of liquidity is not a matter of course. It requires the business owner to take one of two options. One would require the deposit of the full amount in cash with the issuing bank or financial institution. The alternative would require obtaining a line of credit from the bank for use as collateral. This requires the business qualify for bank financing; but it is the preferred alternative as it does not tie up cash. For this reason, the more appealing method is the line of credit option.
It is because such arrangements are not easy that factoring has become increasingly popular. The market for factoring has been growing in the United States. In the domestic market factoring reached over 87 billion dollars in the year 2000 according to the Commercial Finance Association. This meant that this method constituted the largest single method of financing credit sales.
Factoring is best for companies that have exhausted their reliance on banks. In this arrangement, the funder provides the letter using the purchase order as collateral. This factor charges a percentage of the invoice value as commission. Functionally, this is not a loan. It is a purchase of receivables. There are three parties in such a transaction. While credit worthiness of the borrower is key for banks, the value of receivables is its main determinant. Financing is not conditional. There are no long term commitments or a lengthy application process. Cash flows are evened out for businesses not expecting payment for months. The factor evaluates the creditworthiness of the customers. Funding is possible within 24 hours. Letter of credit factoring reduce or remove the risk factors in trade.
About the Author: Accutrac Capital Solutions offers
purchase order financing
and
letter of credit
to help business structure their financing.
Source:
isnare.com
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