How Letter of Credit Limits Are Approved: A Complete Guide for Businesses

For many businesses involved in manufacturing, trading, imports, exports, and large-scale procurement, access to a Letter of Credit (LC) facility can be as important as access to working capital finance itself.

Suppliers often seek assurance regarding payment before dispatching goods, particularly when dealing with new customers, large order values, or cross-border transactions. A Letter of Credit bridges this trust gap by providing a bank-backed commitment that payment will be made upon fulfillment of agreed terms and conditions.

However, unlike a simple banking transaction, a Letter of Credit represents a contingent financial commitment by the bank. If the buyer fails to honor its payment obligation, the bank may be required to make payment on behalf of the borrower. Consequently, banks follow a detailed credit appraisal process before sanctioning LC limits.

Many businesses assume that LC limits are approved solely based on turnover or collateral. In reality, banks evaluate a wide range of factors including financial strength, working capital requirements, industry risk, banking conduct, management quality, and repayment capability.

Understanding how banks approve Letter of Credit limits can help businesses prepare stronger proposals, improve approval chances, and secure adequate trade finance support.

What Is a Letter of Credit?

A Letter of Credit is a non-fund based banking facility through which a bank guarantees payment to a supplier on behalf of a buyer, subject to compliance with specified terms and documentation requirements.

In simple terms:

• The buyer purchases goods.

• The supplier seeks payment assurance.

• The bank issues a Letter of Credit.

• The supplier dispatches goods.

• Payment is made upon submission of compliant documents.

The supplier gains confidence because the bank stands behind the payment obligation.

Why Businesses Need LC Limits

Letters of Credit play a crucial role in trade financing.

They are commonly used for:

Import of Raw Materials

Manufacturers frequently import:

• Chemicals

• Metals

• Electronic components

• Industrial machinery

Suppliers often require LC-backed transactions before shipment.

Domestic Procurement

Large domestic suppliers may also demand LC-backed payment arrangements.

International Trade

Cross-border transactions involve:

• Geographic distance

• Different legal systems

• Foreign exchange risks

LCs provide additional security for both buyers and sellers.

Large Volume Purchases

When transaction values are substantial, suppliers may be unwilling to rely solely on open credit arrangements.

Why Banks Carefully Evaluate LC Requests

Although LCs are classified as non-fund based facilities, they create significant risk for banks.

Many businesses underestimate this risk.

The bank's obligation is not merely administrative.

If the borrower fails to make payment when due, the bank must honor the LC commitment.

This means the exposure can quickly convert from a non-fund based facility into a fund based liability.

Therefore, banks evaluate LC proposals almost as rigorously as traditional loans.

Understanding the Bank's Perspective

Before approving an LC limit, banks seek answers to several key questions:

• Can the company honor payment obligations?

• Does the business genuinely require the facility?

• Are purchase transactions legitimate?

• Is the proposed limit justified?

• Does the company have sufficient financial strength?

• How likely is LC devolvement?

• What would happen if business conditions deteriorate?

The approval process is designed to minimize these risks.

Step 1: Assessment of Business Profile

The first stage involves understanding the nature of the business.

Banks evaluate:

Industry

The sector in which the company operates significantly influences approval decisions.

Examples include:

• Manufacturing

• Trading

• Pharmaceuticals

• Engineering

• Textiles

• Chemicals

• Infrastructure

Certain industries may be viewed as higher risk due to volatility, cyclicality, or regulatory concerns.

Business Model

Banks examine:

• Revenue generation process

• Procurement cycle

• Customer profile

• Supplier profile

• Market position

A stable and well-understood business model generally supports stronger credit assessment.

Experience of Promoters

Management experience often influences lender confidence.

Banks assess:

• Industry experience

• Track record

• Business reputation

• Financial discipline

Experienced promoters are often viewed more favorably.

Step 2: Analysis of Financial Statements

Financial analysis forms the foundation of LC approval.

Typically, banks review:

• Last three years' audited financial statements

• Latest management-certified financials

• Provisional financial data

• Cash flow information

Key Financial Ratios Evaluated

Current Ratio

Banks assess short-term liquidity.

A healthy current ratio indicates the company can meet short-term obligations.

Generally, stronger liquidity supports larger LC limits.

Debt-Equity Ratio

Banks evaluate leverage levels.

Highly leveraged companies may face greater scrutiny because additional obligations increase financial risk.

Interest Coverage Ratio

The ability to service existing debt is important.

Strong coverage ratios indicate better financial resilience.

Debt Service Coverage Ratio (DSCR)

Although LCs are non-fund based, repayment capability remains important because devolvement can create funded debt.

Net Worth

A strong net worth provides financial cushioning and improves lender confidence.

Step 3: Evaluation of Working Capital Cycle

LC limits are generally linked to actual business requirements.

Banks carefully analyze the operating cycle.

This includes:

Inventory Holding Period

How long inventory remains in stock before being sold.

Receivable Collection Period

The average time required to collect customer payments.

Supplier Credit Period

The duration suppliers allow before payment becomes due.

Procurement Volume

The scale of purchases directly affects LC requirements.

Step 4: Determining the Need for LC Limits

Banks do not sanction limits solely because a borrower requests them.

The requirement must be justified.

For example:

A company with annual purchases of ₹120 crore may require significantly different LC support than a company with annual purchases of ₹20 crore.

Banks evaluate:

• Purchase volume

• Procurement patterns

• Supplier requirements

• Seasonal fluctuations

• Import dependence

The proposed LC limit must align with actual business needs.

Step 5: Review of Existing Banking Arrangements

Banks examine current facilities with:

• Existing lenders

• Consortium banks

• Multiple banking partners

They assess:

• Existing LC limits

• Utilization patterns

• Repayment history

• Banking conduct

Consistent and disciplined banking behavior strengthens approval prospects.

Step 6: Assessment of LC Utilization Patterns

For existing borrowers, historical utilization plays an important role.

Banks review:

Frequency of LC Usage

Whether facilities are regularly utilized.

Peak Utilization

The highest level of utilization during the review period.

Average Utilization

Average usage often helps determine appropriate sanction levels.

Devolvement History

One of the most critical review areas.

If previous LCs have devolved due to payment failures, banks may become more cautious.

Step 7: Analysis of Supplier Relationships

Banks evaluate supplier concentration risk.

Questions often include:

• Who are the major suppliers?

• How long has the relationship existed?

• Are suppliers domestic or international?

• What payment terms apply?

Stable supplier relationships typically support approval.

Step 8: Evaluation of Import Transactions

For import LC facilities, banks conduct additional assessments.

These may include:

Import Dependency

The extent to which business operations rely on imports.

Foreign Exchange Exposure

Potential currency-related risks.

Country Risk

Certain jurisdictions may present elevated risk levels.

Regulatory Compliance

Import transactions must comply with applicable regulations and trade policies.

Step 9: Security and Collateral Assessment

Although LCs are non-fund based facilities, banks often seek security support.

Security may include:

Primary Security

• Inventory

• Receivables

• Current assets

Collateral Security

• Commercial property

• Residential property

• Industrial land

• Fixed deposits

Corporate Guarantees

Support from group companies.

Personal Guarantees

Commitments from promoters and directors.

Step 10: Credit Risk Assessment

Banks assign internal credit ratings to borrowers.

These ratings consider:

• Financial performance

• Industry risk

• Management quality

• Market position

• Banking conduct

• Cash flow strength

Higher-rated borrowers generally receive:

• Larger limits

• Better pricing

• Faster approvals

Step 11: Internal Credit Appraisal

Once information is collected, the credit team prepares a detailed appraisal note.

The appraisal typically covers:

Company Overview

Business history and operations.

Financial Analysis

Ratio analysis and trend assessment.

Working Capital Assessment

Funding requirements and cycle evaluation.

Risk Analysis

Potential business and financial risks.

Facility Recommendations

Suggested LC limit and terms.

Step 12: Credit Committee Approval

Depending on the size of exposure, proposals may require approval from:

Branch Level

For smaller limits.

Regional Office

For moderate-sized facilities.

Zonal Office

For larger exposures.

Credit Committee

For substantial corporate facilities.

Head Office

For very large transactions.

The approval hierarchy varies across banks.

How Banks Calculate LC Limits

There is no universal formula.

However, banks generally consider:

Annual Purchases

Higher procurement volumes often justify larger LC limits.

Credit Period

Longer supplier credit periods may require higher limits.

Peak Procurement Requirements

Seasonal businesses often need additional support.

Inventory Levels

Higher inventory requirements may influence sanction size.

Working Capital Assessment

Overall funding requirements are considered.

Common Reasons for Rejection of LC Limit Requests

Many LC proposals are declined due to:

Weak Financial Position

Poor profitability or inadequate net worth.

Excessive Debt

High leverage increases lender risk.

Poor Banking Conduct

Irregular account operations.

Previous LC Devolvement

Past payment failures significantly affect approvals.

Inadequate Justification

Requested limits exceed business requirements.

Weak Documentation

Incomplete financial information.

Industry Concerns

Businesses operating in stressed sectors may face additional scrutiny.

How Businesses Can Improve Approval Chances

Several practical steps can strengthen an LC proposal.

Maintain Healthy Financial Ratios

Strong liquidity and profitability improve lender confidence.

Improve Banking Discipline

Timely repayment and proper account conduct matter significantly.

Reduce Debt Levels

Lower leverage improves overall credit quality.

Strengthen Net Worth

Higher equity support enhances financial stability.

Provide Accurate Projections

Realistic forecasts improve credibility.

Demonstrate Genuine Business Need

Banks are more likely to support facilities backed by clear operational requirements.

Maintain Strong Supplier Relationships

Stable procurement arrangements indicate operational strength.

Relationship Between LC Limits and Credit Ratings

Credit ratings often influence the ease with which businesses obtain trade finance facilities.

Companies with stronger credit profiles generally benefit from:

• Better access to LC limits

• Lower commission charges

• Reduced collateral requirements

• Improved lender confidence

This is particularly relevant for larger corporate borrowers and businesses involved in international trade.

The Role of Professional Advisory Support

Many businesses struggle to present their financial position effectively during the appraisal process.

Professional advisory support can help companies:

• Assess LC requirements accurately

• Improve financial presentation

• Strengthen banking proposals

• Address risk concerns proactively

• Improve communication with lenders

Proper preparation often leads to smoother approvals and better facility structures.

Conclusion

Letter of Credit limits are far more than simple trade finance facilities. Although classified as non-fund based limits, they represent significant contingent liabilities for banks and therefore undergo a detailed approval process.

Before sanctioning LC facilities, banks evaluate the borrower’s business model, financial strength, working capital cycle, procurement requirements, management quality, banking conduct, collateral support, and overall creditworthiness. They also assess the likelihood of devolvement, since a non-fund based commitment can quickly become a funded exposure if payment obligations are not met.

Businesses that maintain strong financial discipline, healthy liquidity, sound banking conduct, and transparent communication with lenders are generally better positioned to secure adequate LC limits. Understanding how banks evaluate and approve these facilities enables companies to prepare more effectively, strengthen lender confidence, and support long-term business growth through reliable trade financing arrangements.