Letter of Guarantee – Definition

Cite this article as:"Letter of Guarantee – Definition," in The Business Professor, updated September 15, 2019, last accessed September 21, 2020, https://thebusinessprofessor.com/lesson/letter-of-guarantee-definition/.

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Letter of Guarantee Definition

A letter of guarantee is a contract that a supplier gets from the client’s bank to assure payment after supply. The letter is insurance for the supplier in case the client is unable to meet his end of the bargain. The bank will then pay the supplier the amount they agree on once the process is complete.

A Little More on What is a Letter of Guarantee

The client is the one who applies for the letter of guarantee from their bank. The application process is similar to a loan application. The bank checks the background of the client for any defaulter records, or if the client is clean and repays loans on time. If the bank is satisfied, they will support their client with the letter of guarantee at a yearly fee.

Who requires a letter of guarantee?

A company dealing with a new supplier

New suppliers often require a letter of guarantee from the company because they do not have the payment history of the company. A lot of uncertainties exist between the customer and the supplier. The client has to apply for the letter as the supplier is not willing to trade the goods on credit, or without immediate initiation of payment after delivery.

A start-up company

Start-up companies may not have sufficient funds to start the financing of equipment or good they require. The company may not even have enough credit history for the supplier to judge their payment capabilities. In such cases, the bank may back them by providing them with a letter of guarantee when they are making their purchases.

A company that deals with overseas suppliers

A company could be doing trade with a supplier who is not from within the country. The supplier will require proof that the client is going to pay them after the delivery of goods. In most cases, overseas suppliers incur additional costs because they are trading outside the country. The company needs to apply for a letter of guarantee to show the supplier that they are committed to paying for the goods they will receive.

Apart from supplying goods, the bank can also issue a letter of guarantee in the following business areas;

  • When a construction company is employing new contractors
  • Leasing of lands, buildings, and large equipment
  • Declaring the import and export of goods
  • Financing from large financial institutions

To guarantee a call writer that they own some core assets and that the bank will give them the assets in case they exercise the call action.

The process of issuing a letter of guarantee

When issuing a letter of guarantee, any bank follows the following process:

The bank examines the request

When the customer sends the request for application, the bank scrutinizes the history of the client and ensures they qualify for the letter of guarantee. The bank can request any additional information from the customer for further examination. After the bank is comfortable with the client’s history, it then issues the letter.

Charges

The bank charges an annual application fee for the applicants of the letter of guarantee using the bank’s rates and policies.

Amending the letter of guarantee

The bank offers both parties a chance to change the terms of their agreement. The subjects of change may be the assets at hand or the validity period of the letter.

Making of payments

After the supplier supplies the goods to the client, they can claim for payments from the customer’s bank. The bank notifies the customer before making any payments. They examine the agreement forms and then settle the amount equal to the goods purchased.

Post-guarantee managing

Once the bank completes the payments to the supplier, it updates the changes made in its records. The bank also keeps the letter of guarantee to verify the necessary transactions. The bank then revokes the guarantee after settling the claims of the supplier and refunds any surplus to the customer.

Examples of letters of guarantee

Example One

Let us assume a Company ABC wants to buy custom made equipment for one of its shops. The equipment is going to cost the company $2 million. The procurement team talks to the suppliers and the suppliers say that they will need several months to create the equipment that the company wants.

So, the company decides not to pay for the equipment until the supplier fully makes it. The supplier, on the other hand, does not want to spend time and resources making equipment that the company may end up not buying. The supplier wants some assurance from its clients that they are going to pay for it at the end of manufacturing.

The company goes to the bank and applies for a letter of guarantee so that they can assure the supplier that they will pay for the equipment. The bank is backing the company, and so the supplier knows that they will receive payment for the equipment they are going to make.

Example Two

Assume company ABC is a subsidiary of company XYZ. Company ABC wants to build new machinery, so they decide to borrow $12 million from their bank. The bank will require the parent plant XYZ to issue them with a letter of guarantee before offering ABC the loan. By doing this, Company XYZ agrees to repay the loan using any means of cash flows in case ABC is unable to settle the loan on its own.

Conclusion

Having a letter of guarantee does not always guarantee payment of the entire amount. The guarantor of the letter can also default from payments of the liabilities if they are struggling as well.

However, it mitigates the risk of the supplier not receiving any payments after supplying a company with products. The letter provides a security layer, and that is why the securities guaranteed to get high credit ratings.

References for “”Letter Of Guarantee

https://www.investopedia.com/terms/l/letter_of_guarantee.asp

https://corporatefinanceinstitute.com › Resources › Knowledge › Finance

https://smallbusiness.chron.com › Finances & Taxes › Financial Risk

https://investinganswers.com/dictionary/l/letter-guarantee

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