A revolving letter of credit is a financial instrument often used in international trade to facilitate transactions between buyers and sellers. It is a type of letter of credit that allows the buyer to make multiple drawdowns (or “draws”) within a specified period, typically a year, up to a certain limit.
If you’re in the business of importing and exporting, or any type of buying and selling, a revolving letter of credit can allow for smoother transactions. Once in place, it allows both buyers and sellers to be more confident in their business arrangements. It also helps to ensure that goods arrive — and all payments are made — on time.
Here, we’ll look at the specifics of revolving letters of credit. We’ll dive into:
• What is a revolving letter of credit
• How a revolving letter of credit works
• The different types of revolving letters of credit
• Limitations of revolving letters of credit
• The pros and cons of a revolving letter of credit
What Is a Revolving Letter of Credit?
When you hear the phrase “revolving credit,” it may sound familiar from personal finance tools you’ve used, such as credit cards and home equity lines of credits. These revolving credit accounts have a credit limit, which represents the maximum amount that you can spend. You can draw on the account up to the limit. Then, as you pay back the amount you owe, the amount of credit will rise back to its original value.
Like the revolving credit you use in your personal finances, revolving letters of credit help streamline financial transactions. However, they work in a different way.
Revolving letters of credit offer convenience and added flexibility for buyers and sellers engaged in ongoing trade relationships, as they eliminate the need to establish a new letter of credit for each transaction. More specifically, they are used to facilitate the regular shipments of goods or the delivery of services between buyers and sellers. You often see them in international trade, in which the buyer and seller are operating in two different places and/or regulatory environments.
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How Does a Revolving Letter of Credit Work?
Here’s a step-by-step look at how revolving letters of credit work work in the business world.
• Opening the letter of credit: The buyer and seller agree to use a revolving letter of credit for their transactions. The buyer applies for the letter of credit from their bank (called the issuing bank) and specifies the terms and conditions, including the amount and validity period.
• Issuance: The issuing bank issues the letter of credit, which serves as a guarantee to the seller that they will receive payment for the goods or services as long as they comply with the terms and conditions of the letter of credit.
• Shipment and presentation of documents: The seller ships the goods or provides the services to the buyer and prepares the necessary documents as specified in the letter of credit, such as invoices and packing lists.
• Drawdown: Upon shipment, the seller presents the required documents to the issuing bank through their own bank (called the advising bank) to request payment. The issuing bank examines the documents and, if they comply with the terms of the letter of credit, makes payment to the seller.
• Revolving feature: After the first drawdown, the letter of credit does not expire. The buyer can continue to make additional drawdowns up to the specified limit and within the validity period of the letter of credit without the need for the issuing bank to issue a new letter of credit.
• Payment and settlement: The buyer is required to repay the issuing bank for the amount of each drawdown, typically on a predetermined schedule. The buyer can also choose to pay the entire outstanding balance at once.
• Renewal: Once the specified period or limit is reached, the letter of credit can be renewed by the buyer and the issuing bank if both parties agree.
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Types of Revolving Letters of Credit
Revolving letters of credit can generally be subdivided into two main categories, one based on value and the other based on time.
Time-Based Revolving Letter of Credit
Some revolving letters of credit are based on time. This means a specific payment amount can be drawn down over a set time period. For example, an importer could have a revolving letter of credit worth $120,000 drawn to cover a six-month period. During that time, payments of $20,000 could be made to an exporter each month. At the end of the six-month period, the revolving letter of credit expires.
Cumulative Revolving Letter of Credit
The time-based resolving letter of credit can be subdivided again into two different subcategories: cumulative and non-cumulative revolving letters of credit. If the revolving letter of credit is cumulative, then previously unused limits can be shifted ahead and used in subsequent time periods. In the example above, if the exporter doesn’t ship any goods in the second month, then it could ship $40,000 worth of goods in month three.
This type of set-up provides the seller with a certain amount of flexibility. However, it can be riskier for the buyer who isn’t receiving goods regularly.
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Non-Cumulative Revolving Letter of Credit
The other type of time-based revolving letter of credit is non-cumulative. This means that previous unused amounts of credit cannot be rolled over into a subsequent month. So, if the exporter in the example above doesn’t ship any goods in the second month, only $20,000 worth of goods can be shipped in each of the subsequent months.
This set-up is less risky for the buyer, because it locks the seller into shipping goods within a narrower time period and under more specific conditions. If the seller doesn’t supply the promised goods within a certain period, they cannot carry that over into a subsequent period.
Value-Based Revolving Letter of Credit
The other main type of revolving letter of credit is the value-based revolving letter of credit. It’s much like its time-based counterpart. The biggest difference is payment from the buyer is only released when they receive goods worth a certain value.
Say, for example, a revolving letter of credit is issued for $120,000 over six months for goods worth $20,000 each month. The exporter can only ship and receive payment for goods worth $20,000 each month. If, for example, they are only able to produce $15,000 worth of goods in one month, they cannot ship the goods to the seller, and the seller won’t provide payment. In this case, the value is very specific, and it really matters.
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Advantages of Revolving Letters of Credit
So why issue a letter of revolving credit? Here’s a look at some of the benefits they offer:
• It can save time and money.
• Because it is revolving, the letter of credit does not need to be reissued for each transaction during a set period.
• It helps facilitate regular trade between a buyer and a seller.
• It can help build trust between buyers and sellers.
• It can incentivize sellers to manufacture a consistent level of goods, especially for non-cumulative and value-based letters.
• It can provide flexibility in terms of the types of agreements buyers and sellers can enter into.
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Disadvantages of a Revolving Letter of Credit
Despite the advantages listed above, there are some limitations and drawbacks to consider:
• Letters of credit tend to be limited to one supplier only.
• They don’t apply to one-time transactions.
• Changes, such as changes to tax law, customs rules, or product design may require amendments to the agreement.
• Bank fees may make revolving letters of credit costly, especially for applicants.
The Takeaway
If you run an importing business and you’re buying goods from overseas — especially from an exporter that represents a new business relationship — a revolving letter of credit can make things easier. It can remove some of the risk of the transactions as you build trust with this new supplier. Of course, if you’re an exporter, the same applies.
That said, it’s important to consider the limitations of using a letter of credit, in particular the cost, and weigh that against the benefits. Before agreeing to a revolving letter of credit, it’s important to explore how this financial instrument fits into your company’s overall needs and goals.
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FAQ
When should a revolving letter of credit be used?
Generally, a revolving letter of credit should be used when there is an ongoing business relationship between a buyer and a seller, and the buyer needs to make multiple transactions over a period of time. It can be particularly useful for businesses that have regular import or export requirements and want to streamline the payment process.
Who issues the revolving letter of credit?
The revolving letter of credit is issued by the buyer’s bank.
What is an irrevocable revolving letter of credit?
An irrevocable revolving letter of credit is a type of revolving letter of credit that cannot be changed unless all parties involved agree to the modifications of the contract. This provides a high level of assurance to the seller that they will receive payment as long as they meet the terms and conditions of the letter of credit.
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