A letter of guarantee is a document issued by your bank that ensures your supplier gets paid for the goods or services it provides to your company, in the event that your company itself can’t pay. In that case, your bank will pay your supplier up to a specified amount.
A letter of guarantee is different from a commercial letter of credit, which commits the bank to pay the supplier directly on your behalf when the services are rendered, whether your company has the ability to pay, or not.
Your company might request a letter of guarantee from your bank when your suppliers are uncertain about your ability to pay. This may happen when:
- Your company is working with a new supplier that does not want to offer trade credit (i.e., allow the purchase of goods or services without immediate payment).
- Your company is in start-up mode and doesn’t have enough credit history for a supplier to judge your ability to pay.
- Your company is dealing with a supplier outside its normal trading area or in another country.
To get a letter of guarantee for one of your suppliers, your company must apply to your bank just like any other loan application. If approved, your bank essentially transfers its credit rating to your company, so the supplier company can rely on it for payment. This makes it easier for your company to buy the products and services it needs.
As long as your company is able to cover its expenses, it won’t actually require the bank to pay any of its bills, which is why a letter of guarantee is also known as a “standby loan.” Companies pay an annual fee but no interest for this privilege. The fee is usually a percentage of the total amount guaranteed by the letter.
More about letters of guarantee
The amount guaranteed by the letter does not appear on the company’s balance sheet, but is noted as a contingent liability (a liability that may or may not occur) in the notes to the financial statements.