Credit Limit #HowTo

Considerations about setting up of credit limits in non-financial B2B transactions.

The Credit Limit issues always draw attention from nearly every business function. Being an important topic for sales, marketing and finance they often create disputes.

Despite our desires, there is no one universal method to define customer credit terms. Similarly, there no single formula to calculate a limit in all cases. Nevertheless, this problem is solvable for a particular company or business.  

This is why the following text does not pretend to be a guide on limits set up. It is rather a description of important points to consider while setting up credit limits and writing credit policies.

Why Establish Limit?

Before setting up a credit limit it is worth to define the purpose it will serve. Whatever it is. Worst way is to use it because others do, or because textbook, or consultant, or article on LinkedIn says so. Limit is a way to keep credit exposure under control. But it also restricts sales, profits and cashflow.

Every business is a unique combination of relationships, business processes and strategy. In some types of business limits are natural, but in others they may bring more harm than help. For example a company cleaning offices of a giant like Amazon or Apple. It is unlikely they will refuse to continue service delivery because of ‘exhausted credit limit’.

The limit shouldn't slow down a business process. If too many orders trigger disputes, it is better to change the basic method under it. Ideally a limit should be 'silent'. Meaning that it does not draw unnecessary attention. Goods and services go to customers, payments are coming from them.

Credit Limit and Credit Term

Topic of credit term is quite extensive and deserves its own separate article. This text will touch only its relation with a credit limit.

By definition credit has two key measurements - sum and time. They are interdependent. As natural consequence credit limit and credit term also interconnected. The longer the term, the bigger the limit is necessary. Too short deferred payment term will never allow a customer to use their limit in full. In the same way too low limit will force them to pay earlier despite their term's length.

Inconsistency between the two leads to issues. Neither urgent limit reviews, nor requests for earlier payment make business easier. The care taken of two component's compatibility pays off by time, money and customers’ satisfaction. Thus, limit and term should always be in harmony. Whatever big or small they are.

Limit, term and collateral altogether constitute conditions of credit granted to a customer. Each time one of them needs a review, others have to be re-considered as well.

Credit Limit and Credit Risk

Limit, as well as credit in general, is often perceived as a measure of trust given by a creditor to a customer. Which is obviously true. But businesses grant credit not because of trust only. They do so to gain competitive advantages. As such, limit is also a reflection of risk appetite. A balance between a risk and an opportunity. Important conclusion form the above - credit limit may not be product of any sort of calculation. It is always a management decision. 

Credit Risk has lots of definitions. Most of them agree that this is the risk of payment default. Yet non payment may occur as a consequence of different risk scenarios:

• ID or so called 'quick' fraud 
• political or economic crisis in country 
• compliance issues 
• long-term fraud of company's authorities 
• insolvency

Though incomplete the above list gives an idea of actual credit risk complexity. Each scenario requires specific tools for evaluation. Some of them may presume tolerance, some not. Country and Insolvency Risks have measurements, although not always precise. Tolerance to Fraud and Compliance is out of common sense. Long-Term Fraud is extremely difficult to predict and avoid. All these need careful consideration within the process of decision-making.

Boundaries of Optimal Credit Limit

If one will ask sales and finance about how to define credit limit, their answers will be as follows:

• sales will suggest to take sales forecast or target, divide it by days and multiply by credit term 
• finance will be of opinion to use financial statements and assess credit risk 

Two opposite approaches are natural for their authors. Sales concentrate on how much credit is Needed to achieve targeted volume. Finance look at how much is Safe to trust to a particular counterpart. Neither of them is good enough to define limits. But together they help to find boundaries of space where an optimal credit limit could be in.

The finance approach helps to establish an amount which could be safely trusted to a company without any collateral. Its name could be Creditworthiness and it establishes the lower level of a limit. The method of sales helps to find the need for credit, or better say Credit Demand. It establishes the upper level of a sought limit. 

The margin between the upper and lower levels can be huge. Nevertheless, any credit limit outside space, confined by them, makes no sense. In practical use, comparison of CreditWorthiness and Credit Demand helps lot with decision making as well as with communication with non-specialists.

Credit Limit and Security/Collateral

The modern financial market offers many good tools to protect receivables. Letters of Credit, Guarantees, Insurance and others help companies to reduce bad debts. They also help to make deals which otherwise won't happen due to high credit risk.

Nevertheless, these do not create a reason to outsource decision-making to a 3rd party. Credit Limit is a management compromise between risk and opportunity. In some cases it is possible to establish limits based on security instrument. But this decision should be taken with a clear understanding of all possible cases. First of all, those where the provider revokes instrument.

In parallel, the use of credit security requires tough control. The validity period of any instrument is usually very strict. It comes into force on the date of issuance and becomes a piece of paper upon expiry date. If credit conditions are granted based on a security, they should be perfectly coordinated.

Limit “Mobilis in Mobile”

If a company increases limit each time a customer places a new order this means there is no limit. From the other side, whatever optimal limit is for today it wouldn’t stay so forever. 

Credit Demand, affected by sales forecast, changes continuously. CreditWorthiness of a business also changes nearly every day. Therefore, credit limit review should is necessary each time any of two above updated. 

For example, new credit demand helps to see whether current limit is still enough to support sales. Updated creditworthiness allows to see changes in risk exposure. Regular reviews, conducted beforehand, allow for prevention of issues instead of trying to solve them in restricted time. 

In practice, creditworthiness should be re-evaluated each time fresh financial statements are available, but not less than once a year. Similarly, update of credit demand takes place with every new sales forecast. 

Conclusion 

Management of trade receivables has never been an easy task. Businesses try tackle it from different ends. Some start with cash collections, others with control. However, most part of results comes from thoroughly thought credit terms. This time and efforts spent on credit analysis, limits establishment and review will never be wasted.