Tuesday, 28 February 2017 13:20

How to Set Appropriate Credit Limits

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In today’s economic climate, business customers and clients are increasingly asking for - and in many cases expecting - credit from their suppliers.

There are obviously many benefits to offering credit. It shows a willingness to be flexible which fosters stronger business relationships, and it helps to secure or keep important contracts. Used properly, extending credit for goods and services can give your business a competitive advantage and boost income.

However, there are risks involved. Delaying or staggering receipt of payments can lead to cash flow difficulties if not prepared for properly. Having cash in the bank or a long list of IOUs are two very different things, and the less ready cash a business has available at any one time, the more vulnerable it becomes to defaults and late payments.

Credit limits are intended to reduce some of the exposure to these risks without scrapping credit provision altogether. As a business owner, it is natural to want to meet client’s expectations and show willingness to meet them halfway over payment arrangements.

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But that does not have to be at the risk of your own company’s financial security. By setting a cap on how much a client can spend on credit, you gain control over delays to payment so it is manageable for your cash flow. And you also mitigate against potential payment issues down the line.

Calculating a Credit Limit

The most important factor in credit control is the level of risk a business can afford to be exposed to. Calculating credit limits is not an exact science, as it depends on the financial circumstances of individual companies.. Cash flow and the risk of defaults on payment need to be factored in. From that, a level of acceptable risk can be quantified.

Some businesses simply use that raw figure as their credit limit and stick to it. There are, however, three common calculations used which to a greater or lesser extent offer flexibility in managing credit control.

  1. Net Worth: This calculates a credit limit as a percentage of a client’s net worth, working capital or average monthly sales - 10 per cent is typical. The key advantage of this method is that it is bases credit on a client’s financial circumstances, avoiding the risks of extending too much credit to a company that cannot afford it. Financial information can be obtained by asking clients to complete a credit application or by securing a credit report.
  2. Trade References: The credit limits extended to a business by other suppliers again provide a good benchmark for what they can afford, but also gives an insight into their expectations. This information can be obtained through the references provided on a credit limit application form.
  3. Needs Based: This puts the ball back into the client’s court - what kind of credit facility are they looking for? If it is within a creditor’s level of acceptable risk, an agreement can be reached. This has the advantage of building strong relations through excellent customer service. It also allows for a degree of flexibility in the arrangement as needs change.

Implementing a Credit Limit

Occasionally business owners take umbrage at suppliers imposing a credit limit. But every company has the right to protect its own financial interests. Be open from the very beginning that this is what you do. Advertise the fact that you offer credit, but state clearly that customers will have to complete a credit application.

It is always a good idea to take a flexible approach. Instead of using one fixed method of calculation, use them all. Work out a level of exposure your business can handle, do the net worth and trade reference calculations, and then negotiate according to what the client’s credit requirements are.

Finally, be clear about your strategy when a client nears their credit limit - some are bound to ask for more. If you want to enforce limits strictly, and will not supply further goods or services once they are reached, be clear about this from the start. If you want to be more flexible, use information gathered from credit reports, credit applications and payment histories to make an informed decision about the additional risk you are taking.

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