If your company has financial obligations, such as payments to an insurance company, you can obtain a letter of credit, which essentially states your intention to pay the debt.
But while the lure of using LOCs can be tempting, the advantages they bring do not come without risk.
Daniel R. Slezak, vice president with ECBM Insurance Brokers and Consultants, says using LOCs will reduce a company’s borrowing capacity with its bank, which can leave business owners with their hands tied if an opportunity for growth comes along.
“If your business has shown a need to borrow money as a catalyst for growth, a large LOC amount may be limiting your capacity to do just that,” Slezak says.
Smart Business spoke with Slezak about how LOCs can strangle your growth and what alternatives businesses should consider.
What is a letter of credit, and why would a company need or want to use one?
A letter of credit is a legal commitment issued by a bank that states the bank will pay monies on behalf of its customer to the holder — in this case an insurance company — upon demand. You would use an LOC to secure your obligations to the insurance company, which has required you to post collateral to insure future payment obligations.
LOCs are also sometimes used as a protection tool when doing business internationally. Companies can receive a letter of credit to ensure they will get paid for what they are selling before they release it to the buyer. Or they can issue a letter of credit to ensure that they get what they are expecting to get before they pay for it.
What are the pros and cons of using letters of credit?
The first advantage is that the rate to post the LOC is lower than the rate the company would have to pay to borrow money to fulfill its obligation.
The second advantage is that the LOC is an ‘off balance sheet’ form of financing. That makes it different than a direct loan, which would have to be shown as debt on the company’s balance sheet.
There are also disadvantages that need to be considered. Using LOCs does reduce a company’s borrowing capacity with its bank. Also, the cost of LOCs has skyrocketed for even the best, most creditworthy customers. Banks now have to expend capital to support LOCs because of risk-based requirements that have been imposed on them. The bank will meet those requirements and support your LOC, but for a fee.
