Why Use Trade Credit Limits?
Anyone with a credit card should be familiar with credit limits. It’s the maximum amount of credit your card provider is prepared to let you have.
The principle is the same when using credit limits in a business. It’s the maximum value of unpaid invoices you can have outstanding at any given time.
How Do You Decide What Credit Limit to Set?
Setting credit limits is not about how much you trust someone or your gut feeling. They need to be more calculated than that.
You need to apply a consistent method of calculating a credit limit based on data about your customer.
As a basic rule, customer credit limits should be set high enough to accommodate their typical purchase requirements but low enough that credit risk can be appropriately managed.
If you don’t have a credit analyst to calculate a credit limit based on financial, operation and environmental data, a credit reference agency report may be the answer.
Many credit reference agency reports suggest a credit limit based on all the available data (which is usually very extensive). Whilst I have seen two agencies give quite different credit limits for the same company, they are generally very similar.
A bit like speed limits, though; these are upper limits, not targets. As such, any limit you set needs to be aligned with your risk appetite, your business’s financial position and the anticipated value of your customer’s purchases. Otherwise, they will not act as the early warning system they should be.
Not Set in Stone
Credit limits should not be set in stone.
A credit reference agency monitoring service will alert you to any changes that could impact the recommended credit limit, such as filing their latest accounts.
In addition, keeping a close eye on your customer’s payment and buying patterns will allow you to adjust their credit limit accordingly. This will enable you to take advantage of any opportunities presented by being able to increase a credit limit or ensure that you’re protected from any increase in risk.
If a customer requests an increase in their credit limit, which is not uncommon, you should consider the reason for the request as well as the data. If the data say no, consider asking for a personal or director’s guarantee as additional protection.
The Benefits of Using Credit Limits
You are assuming all the risk if you don’t use credit limits and always accept your customers’ orders for whatever value of goods or services they want. The bigger the order or total value of orders, the bigger the risk.
Leverage Quicker Payments
Credit limits encourage customers wanting to place further orders to pay their outstanding invoices faster.
However, they only act as great leverage when you stick to your credit limit. With all things about payment, your actions educate your customers. So if you don’t enforce credit limits, your customers will take advantage of that and act as if there is no limit.
The administrative burden of debt recovery involves staff time, internal tracking systems, postage, and phone expenses. Not to mention legal costs if it gets that far.
These costs are reduced if you can use credit limits to leverage quicker payment.
Limit Bad Debt Losses
Setting credit limits is all about limiting your exposure to potential bad debts. By restricting the total amount of credit a customer can have outstanding at any given time, you limit the impact on your profit should they fail to pay you.
Without credit limits and a mechanism for enforcing them, your customer can keep placing orders and racking up debt they may be unable to repay.
Putting Orders on Stop
Credit limits can be a trigger for suspending the provision of any more goods or services until payment has been received.
Without credit limits, you can still do this, but it will inevitably not be applied consistently without the trigger point.
You need to have this right in your Terms and Conditions as a remedy for late payment.
Trade Credit Insurers
Many trade credit insurers require credit limits on the customers they are insuring. Often they will take some control over what the credit limit will be. Should you need to make a claim and you’ve allowed your customers to exceed these limits, the over-limit balance will not be covered.
Get in touch if you’d like to find out how good credit management can prevent late payments and improve your cash flow.