Here at ScotPac, our team provides flexible and tailored financial and working capital solutions to clients from across Australia and New Zealand. Among the many solutions we explore on behalf of our clients are invoice finance and letters of credit.
Invoice finance vs letters of credit – understanding the difference
In short, invoice financing allows a business to access capital to the value of their issued but yet-to-be-paid invoices. Both invoice factoring and invoice discounting are sub-forms of invoice finance.
By contrast, letters of credit are provided by a banking institution and outlines that they guarantee payment to a seller on behalf of a buyer should all the terms and conditions of the letter be met. Letters of credit are commonly used to sell goods between importers and exporters.
Both of these financial instruments/methods offer unique solutions for companies looking to grow and scale their operations.
Invoice finance: A deeper dive
In invoice finance, the unpaid invoices issued to customers or clients is used as security for the loan or funding. The amount that a company can access may vary but can be a significant percentage of the total value of the invoices.
Invoice financing is a good and often quick solution, but every provider will have its own risk criteria and offer contracts accordingly.
Generally, companies looking to use this form of access to do so for one of the following purposes:
- Improving cash flow
- Enabling an alternate investment
- Accessing required funds quickly
- Capitalising on a balance sheet asset that has been previously unused
- Flexible spending without overly restrictive conditions
- Fund raising without losing equity
Invoice discounting vs invoice factoring
Invoice factoring
Invoice factoring works by allowing a business to access a specified amount of funding against the value of their issued invoices.
Most providers will lend anywhere up to 90% of the value of the invoices. Often, they will also collect payment of the invoices directly from your clients or customers. Associated costs of the invoice factoring admin and arrangement are then deducted from the payment of any remaining balance at the end of the agreement.
Invoice discounting
Invoice discounting is similar to invoice factoring but with the core difference of the business itself–and not the finance provider–maintaining control of collecting the payments from the customers or clients.
If your business uses the funding, you will then be required to pay the associated and agreed to fees as well as any other charges, such as interest.
Letter of credit: what you need to know
The letter of credit–also referred to the other way round as a credit letter–is provided by a bank on behalf of a buyer, most often an importer, as assurance that a payment will be provided at the full, correct amount and at the agreed time.
In the event that the buyer does not or is unable to make the payment, the bank that issues the credit letter will cover the cost. This payment may be the full amount or a remaining portion of the overall cost.
Put simply, the letter of credit acts as a guarantee on behalf of the buyer. While it can be provided as a facility, it is not necessarily the case.
International letters of credit
Letters of credit are widely used between importers and exporters who, by definition, operate in different markets and countries.
As with all international transactions, the difficulties of distance, laws, culture, and language can be significant. Letters of credit, being a reliable guarantee of payment from a reputable bank, are therefore critical and very valuable for trade.
Fees
Banks collect a fee from the buyer on whose behalf they issue the letter. The exact structure and terms of this fee can vary, so make sure to speak to your financial advisor and institution in the event you are exploring this option.
Eligibility
Banks, understandably, do not just offer a letter of credit to any business. Due to the fact that they are taking responsibility for the payment and guaranteeing that the payment will be made, the business requesting the letter will need to have either an adequate line of credit or enough assets to reassure the bank that they can cover the payment to the seller.
Types of letters of credit
1. Standby (standard)
A standby letter of credit, which is the standard form, is when the bank only pays the outstanding amount in the event the buyer cannot.
2. Commercial
A commercial letter of credit is the simplest type where the bank pays the seller directly regardless.
3. Revolving
The revoking letter of credit allows the buyer to make multiple drawers (within the terms and conditions) over the pre-agreed period of time.
4. Traveler’s
This specific type of letter of credit is made between local and foreign banks.
5. Confirmed
The confirmed letter of credit is when a second bank is involved in addition to the one providing the guarantee through the credit letter. This second layer involves a bank confirming that they will cover the cost in the event that both the buyer and the first bank default.
Advantages and disadvantages
The pros of a letter of credit include:
- Security for both the buyer and seller in a transaction.
- The guarantee of a bank’s financial backing.
- Sellers are able to borrow against the full receivable amount and buyers are able to ensure transactions or purchases go through.
Some cons to consider include:
- Most often a letter of credit just covers one transaction.
- Security and collateral, of varying amounts depending on the risk profile, is required.
- It can be time consuming, expensive or difficult to obtain.
ScotPac – the biggest non-bank lender in Australia
Whether you’re interested in exploring invoice finance or a letter of credit, make sure to reach out to the team here at ScotPac. We’re the biggest non-bank lender in the country and focus on fostering long-term and mutually beneficial relationships with our clients. Let’s start exploring what sort of flexible and tailored finance solution is best suited to your business today.