The Art and Science of Setting Credit Limits

Credit professionals will extend credit to customers based on factors such as financial risk, creditworthiness and credit history, just to name a few. But once a customer is granted credit, how can you set an effective and reasonable credit limit?

While no standard formula exists to magically calculate an exact credit limit number, an?eNews?poll revealed customer sales volume, payment performance and years in business were the top three ways credit professionals evaluate customers to set credit limits—followed by credit reporting agencies and EBITDA (67%) and Altman Z scores (33%).

Some credit professionals consider their company margins on certain customers and what their growth pattern is—and whether the customer is projected to grow or not. If the anticipated sales volume is greater than what a credit investigation supports, “we work with the commercial team on either obtaining additional financial information from the customer or determining if the financial return supports the additional credit risk,” said Nathan Hutton , CICP, global credit manager at Donaldson Company, Inc. (Minneapolis, MN).

Understanding your company’s risk capacity and risk tolerance is also key when determining the credit limit for a customer. “We rely heavily on our credit reporting tools with the risk tolerance,” Hutton said. “Fortunately, our portfolio of customers tends to be less risky so we typically can accommodate all customer credit limit requests accordingly.”

Risk tolerance is subjective, while risk capacity is objective. Risk tolerance refers to an organization's willingness to accept a certain level of risk based on their comfort level. For example, a well-established company with high margins in a market with growth may have a high-risk tolerance and be willing to sell to high-risk customers. A company with low margins in a highly competitive market may have a lower tolerance for risk and will sell only to financially strong customers.

Risk capacity represents the maximum amount of risk that can be tolerated without causing significant negative consequences. An undercapitalized company may not have sufficient reserves to survive a large loss. Therefore, it has low-risk capacity.

However, negative cash flow is always a concern. Drops in sales or profits and not understanding?why?can impact the credit limit extended, which is why a customer’s creditworthiness plays one of the biggest roles in setting limits. One of the first indicators is the age of the company. “Roughly 80% of all new companies fail within the first five years of existence,” said Hutton, “Because of this, without financial statements, we seldom give net terms to companies still in their infancy.”

Another factor to check before setting a credit limit is if a company does not have a strong relationship with their bank. For example, existing lines of credit with capacity, not out of round on their covenants, can be red flags. Credit reports and trade references are huge when setting credit limits, Hutton added. “We are always looking to see how the customer repays its obligations.”

Typically, both trade and bank references are contacted in order to analyze a customer’s credit worth and history before any limits are decided, said Ty Knox , director of credit and risk at EFCO Corp. (Des Moines, IA). “We use third-party credit providers to buy credit reports on customers,” Knox said. “When we look at a creditworthiness, we must look at more than just the monthly rental we will be charging. We must determine if the customer has the wherewithal to pay in full if something does go wrong.”

But in some cases, a customer’s current financial state may not reflect them as a whole—which is why it is important to dig into the data and use as much information as possible. Red flags could be an odd impairment charge that only happened once, or fallout from a merger and acquisition, said JoAnn Malz, CCE, ICCE , CCE, ICCE, NACM chair elect and director of credit and collections at The Imagine Group, LLC (Shakopee, MN). “Profitability is one factor, cashflow is another and looking at key metrics such as the current ratio is key,” said Malz. “If you have a relationship with your customers and they are providing you financial statements, you can provide some of that detail in their notes.”

When using a scorecard, the score will come with indicators that show where all concerns lie in a customer. And this is where making those gut-feeling business decisions as a credit professional comes into practice. “In credit we have to evaluate all information and possible risks to make a business decision,” said Malz. “I’ve always told my team that our role is to find the red flags, make a recommendation and bring that to management. If they disagree, we must decide whether we want to make a business decision and knowingly take the risk, or take action to mitigate the risk, such as collateral put in place.”

Credit professionals in smaller companies may have tighter than normal credit limits compared to the wider industry. “One thing I suggest credit managers should do is join a trade group to get deeper industry knowledge,” said Frank Beahm, CBA, CICP, credit manager at PING, Inc. (Phoenix, AZ). “It provides a better understanding of needs in terms of the credit risk and tolerance, whereas some companies will open up credit limits and assume more risk, running into deeper aging and higher write-offs.”

Beahm said his company mantra is to crawl before you walk, walk before you run and run before you fly. “I can’t emphasize enough the importance of trade groups because if your product is hot at one moment, they might be paying you and not paying the other company,” Beahm said. “Industry reports give an apples-to-apples comparison of what’s happening so you can set reasonable limits.”

Credit limits are not a “set it and forget it” function of the credit department. Customers should be monitored constantly in case terms need to be clawed back to proactively protect company assets.