Set up the credit limit
|When a seller make a sale to a buyer with a payment term, he grants a loan to its customer. This loan will be resorbed only after bills are paid.
The credit limit is the maximum amount of loan that the seller accepts to grant to its customer.
It depends on:
Set up a credit limit for each customer! If credit limit is reached, you will need to renegotiate the payment terms to limit your risk with your client.
Credit limit does not mean limit of orders. Negotiate advance payments, get additional guarantees (bank guarantees, delegations of payment, credit insurance ... etc) to maximize your sales while controlling the risk of bad debts and improving your working capital.
What is a Credit Limit?The credit limit corresponds to the maximum credit risk that the supplier agrees to take on a particular client.
The credit risk includes the accounts receivable (invoices including taxes + other receivable) and the backlog (orders in hand not yet invoiced).
The criteria used to set up credit limits and the level of risk acceptance should be consistent with your company's credit management strategy. Do you have a policy of strong commercial development, even assuming risk of non-payment or do you want to preserve the profitability of your business above all?
Why is it needed to set up a Credit Limit?Set up a credit limit for each customer is mandatory. The credit granted to customers is similar to a financial loan. Set up a credit limit ensures that the amount of this credit is consistent with the financial capacities of each customer.
Set up credit limits is one of the key tools to avoid overdue invoices and bad debts.
How set up a credit limit?First step is to collect information about your customer:
The required credit limit is the business need of credit limit. It is the product of the estimated sales to come, the schedule of invoicing and the payment term granted to the customer.
Required credit limit can be challenged by negotiation with the customer
Third step is to set up the Credit Limit:
Once required credit limit is calculated, it must be compared to the information collected about legal & financial situation of the buyer, and its payment behaviour.
The Credit Limit has to be consistent with financial capacities of the customer and its payment behaviour.
There are several ways to set a credit limit. Each has advantages and disadvantages.
We have created an innovative method which first includes in the calculation the required credit limit related to your volume of orders and payment terms negotiated. Then the tool (Excel file to download or online tool) compares the amount obtained with the result of the credit ranking (obtained with the credit notation tool) and financial capabilities of your customer.Main criteria are:
Equity in order to compare the credit limit with stable financial resources of your client.
Tangible Net Worth to ensure that the credit limit is proportionately consistent with the intrinsic financial value of your buyer.
Debt providers to ensure that you do not pass from the position of single creditor to the principal funder of your client, especially if the credit exceeds what has been invested by shareholders and bankers. By becoming a primary supplier, you can make your customers dependent on the credit granted.
Turnover. The credit limit should be very significantly lower than the turnover of your client. Be careful to the proportion of credit limit amount / company size of your client.
Operating income. Compare the credit limit to the operating income of your client. It should not exceed 50% of the operating income.Once credit limits are set up, they must be regularly reviewed:
Economical context is changing very fast and it will change faster in future. It is the same for the financial situation of your customers.
Then, every credit limit has to be reviewed at least twice a year or every time the buiness relation is changing (overdue invoices, new orders, negative or positive information obtained about the customer...etc.).
Credit limits require a close monitoring in order to be effective.
ConclusionThe set up of credit limits for each of its private customers is necessary to manage the customer risk and limit its commitment according to buyer's capabilities.
Another advantage, this practice pushes salespeople and other managers to negotiate better terms of payment with customers because it allows to make more sales.
This practice is therefore very beneficial for the company to develop its business while improving its WCR and limiting its exposure to the risk of bad debts.
Even customers can find their interest because some will be happy to negotiate a down payment or an advance payment against an attractive discount.
Next: set up the payment term
This tool is a big help for credit analysts to ensure credit limits are coherent with customer financial situation.
This tool is the most powerful to set up a credit limit according to business need and financial situation of your buyer.
Duration: this the period on the sales value you enter.
Suppliers debt is Account Payable value
Turnover is the sales.
I am interested to learn more about credit limit set up and credit control of my buyers.
You can download the tool "credit limit setup" to learn more about this essential analysis.