Set up the credit limit
The credit limit is the maximum amount of loan that the seller accepts to grant to its customer.
It depends on:
- The assessment of creditworthiness that you previously made. See Credit analysis tutorial and Credit notation,
- Your customer's financial capacity,
- The commercial stakes (key account?),
- The payment term negociated,
- The expected amount of the business.
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).
Credit limits management in My DSO Manager
Use the credit limit set up tool included in My DSO Manager.
It is based on business requirements and customizable financial criteria.
My DSO Manager includes a workflow to validate credit limits according to approbation levels.
Then, use the risk report and alerts to manage credit risk and outstanding receivable compare to the credit limits of your customers accounts.
The software provides with all indicators required to assess the credit limit and the risk. See more with the online demo.
How set up a credit limit?First step is to collect information about your customer:
- Business expected:
- Amount of sales expected with the client,
- Period (in months),
- Payment term considered,
- Sales Manager feedback:
- Key customer or not?
- Position on the market, growing business?
- Reliable or not?
- Legal and financial information about the customer:
- Last profit and loss accounts and balance sheet,
- Company legal form,
- Date of creation,
- References from other suppliers,
- Payment behaviour.
- Customer visit: When the business or the credit risk stakes are high, it is needed to visit the customer to:
- Get fresh information about customer’s financial situation,
- Create a personalized contact with the customer,
- Negotiate financial conditions of the business (payment terms, payment guarantees, schedule of payment...etc.)
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.
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.
Accounts Payable to ensure that you do not switch 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 may not exceed 50% of the operating income.
Pilot your credit limitsEconomical context is changing very fast and it will change faster in future. It is the same for the financial situation of your customers.
Once calculated and validated, the credit limit is a living data which influences daily business relationships.
It is compared to the outstanding receivables plus the portfolio of accepted orders, the sum of which must not exceed it. If the total outstanding reaches the same level then an action to review the limit must be carried out:
- Either new tangible elements make possible to increase the credit limit (new positive financial information, quality of payment behavior, etc.).
- Or this threshold cannot be increased because it is consistent with the financial structure of the buyer. In this case, several solutions are available to pursue the growth of turnover with his client without increasing the risk:
- Request advance payments (possibly against discount) to reduce the outstanding amount.
- Negotiate new payment conditions (reduction of the payment term, get advance payments).
- Obtain an additional guarantee (credit insurance, bank guarantee, parent company guarantee, etc.).
- Finance receivables without recourse (factoring, bank discount without recourse, mobilization of means of payment like drafts or commercial transfer, etc.).
ConclusionThe set up of credit limits for each of its private / limited company customers is necessary to manage 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.
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.