Sight Letter Of Credit Definition
A sight letter of credit is a business document that traders use to verify the payment of goods and services, and the goods are payable as soon as other necessary documents are submitted along with it. A company that offers a sight letter of credit enters into a commitment that it will pay the sum of money involved in the transaction as long as the specifications in the letter of credit are satisfying.
What sight letter of credit means is that payment is due on demand. The issuing bank makes payment as soon as it receives all the complying documents from a business dealer. Note that the word immediately refers to the payment made within 5 to 8 days because the advising bank requires time to review the documents and then submit them to the issuing bank. Once the issuing bank and the buyer verifies and accepts it, it is then that payment is released.
For instance, a business dealer may submit a bill of exchange to the issuing bank, together with a sight of letter of credit, and the bank makes payment upon confirmation. Note that a sight letter of credit, including other documents such as invoice, bill of landing, insurance, and packing list is proof of shipment. A sight letter of credit is the commonly used letter by those in business when compared to other letters of credit
A Little More on What is a Sight Letter Of Credit
Generally, it is the third party in a business transaction that provides a sight letter of credit. The document is verification that payment for the shipment of goods will be made. It contains specific conditions that must be met for the issuing bank to release the money. The conditions may include meeting specific delivery time frames and submission of necessary documents.
A sight letter of credit is different from other contracts in the negotiation, and it requires that all the parties involved agree. Note that the document can be used for both international and domestic transactions.
However, it is commonly used by those involved in international trade transactions. The reason why international traders prefer using this document is that it shifts away risks from both the buyer and seller as there is a bank that is involved. So, in case of any risks, the bank assumes the responsibility.
The issuing bank is supposed to take 5 working days to verify whether or not the documents presented are compliant. After the verification process, it is the responsibility of the bank to ensure that the beneficiary gets paid as soon as possible.
The issuing bank is usually given a reasonable time frame within which it is supposed to process the payment. So, in a presentation where there is no additional reimbursement time-frame, the bank should ensure that the beneficiary gets paid within five business days.
Who are the Parties Involved in a Sight Letter of Credit?
There are three parties involved in a sight letter of credit. There is the buyer, the seller, and the issuing bank. The buyer is also known as the applicant. The issuing bank represents the buyer, and it is the one that makes the payments on behalf of the buyer.
The seller, on the other hand, is the entity that receives the money specified on the sight letter of credit after shipping the goods.
How a Sight Letter of Credit Works (Example)
Let’s assume that John, who in this case is the buyer/importer, resides in Spain and buys goods worth $10,000 from Eddie (a seller) from Japan. Eddie insists that they must use a sight letter of credit in the transaction. John agrees to this term and applies for a sight letter of credit worth $10,000 from his ABC bank in Spain in Eddie’s name. Eddie goes ahead to nominate XYZ bank in Japan as his advising bank.
Note that based on John’s application, ABC bank in Spain issues a sight letter of credit worth $10,000 in Eddie’s name, and submits it to XYZ bank in Japan. The XYZ bank then forwards it to Eddie, where he checks the terms of the document, and he is satisfied with it.
He then ships the ordered goods worth $10,000 to John and receives a bill of landing from the shipping company he has used to ship the goods. Eddie informs John about the shipment by sending him digital copies of the shipping documents.
Upon receiving the documents that show proof of shipment, John goes ahead to make a payment of $10,000 to ABC bank in Spain. However, the bank holds the money and waits for Eddie to submit the original shipping documents and the original letter of credit written to the XYZ bank in Japan.
Eddie hands over the original shipping documents and the letter of credit to XYZ bank. The XYX bank takes two days to review the documents and submit them to the ABC bank in Spain. The ABC bank and John have a maximum of three days to review and confirm the documents. After confirmation, the ABC bank releases the $10,000 payment it is holding to the XYZ bank in Japan. The XYZ bank should credit the money to Eddie’s account the following day after deducting their advising charges.
Take note that the entire transaction was done within a time frame of 7 days, meaning that Eddie got paid on the 8th day after shipping the goods. Also, note that it takes about 45 to 55 days for goods shipped from Japan to reach Spain. So, in the real sense, John had not received the shipped goods by the time Eddie was receiving payment.
When to Use a Sight Letter of Credit
A sight letter of credit is important under the following circumstances:
- When the beneficiary needs money immediately after completing the shipment process
- When there is a small-medium transaction involved, and the location of the applicant is in a relatively high-risk region or country
Advantages of a Sight of Letter of Credit
- It enables the seller to manage his or her working capital more efficiently. The seller will not encounter any cash crunch as he or she receives payment immediately after the shipment of goods.
- In most cases, traders use working capital loans to manage their working capital, especially when the seller gives the buyer a credit period, which takes about fifteen days to three months. What this means is that during this whole time, the seller will have to forgo the interest from the amount the buyer is supposed to pay. So, that is why the sight letter of credit comes in handy. It eliminates this by ensuring that the seller gets interest benefits because the buyer releases his or her money immediately.
- Since there is no credit period involved, the buyer is in a position to negotiate better business terms with the seller. The ability to negotiate for better terms gives the buyer a competitive advantage in the market.
- Generally, there is a low cost involved in the sight of letters of credit, making it a more efficient method of payment in any international trade transactions.
Disadvantages of a Sight Letter of Credit
The risk involved when you use sight letters of credit is that the buyer may receive the wrong goods. Note that in this kind of transaction, the seller gets paid before the buyer receives the goods.
So, more risk lies with the buyer because there is a possibility that he will pay for the goods he or she did not order. The risk can be more extreme if the seller happens to be a fraud, and ships pieces of rock and disappears with the money.
Another disadvantage of using a sight letter of credit is that the buyer has less credit period, so managing his or her working capital cycle may be hectic. Also, since there is no credit period for the buyer, he or she foregoes the interest rates involved in the transaction, a move that disadvantages the seller, as he or she will not get much interest.