How to Set Credit Limits for New Applicants

By Michael C. Dennis, CPC. CCP. CBF.

Setting credit limits for new B2B credit applicants is a crucial task that balances risk management with business development. An appropriate credit limit maximizes sales opportunities while limiting the risk of non-payment. Here’s a more detailed look at the factors involved in setting these limits:

·??????? Balance Sheet Review: Evaluate the applicant’s assets, liabilities, and equity to assess their financial stability. Look for a strong current ratio (current assets divided by current liabilities) to ensure liquidity. A ratio above 1 indicates that the applicant can cover its short-term obligations.

·??????? Income Statement Review: Analyze the applicant's revenue, expenses, and net income to gauge profitability and operational efficiency. Consistent profits and positive cash flow are indicators of a reliable customer. Monitor key ratios like gross profit margin and net profit margin for better insight into profitability.

·??????? Credit Reports: Obtain credit reports from agencies such as Dun & Bradstreet, Experian, or Equifax. These reports provide a detailed history of the applicant's credit usage, payment patterns, and any defaults or late payments. A high credit score suggests low risk, while a lower score may indicate potential issues.

·??????? Payment Behavior: Assess the applicant’s history of payments to other creditors. Look for patterns such as late payments, defaults, or legal actions. Consistent, on-time payments indicate good credit behavior, while frequent delays or disputes could signal an unacceptably high risk.

·??????? Sector Analysis: Consider the economic conditions and inherent risks associated with the applicant's industry. For example, industries like construction or retail might have different risk profiles due to economic sensitivity or seasonal fluctuations. Higher-risk industries may warrant a lower initial credit limit or require more stringent credit terms.

·??????? Market Position: Evaluate the applicant's position within their industry by examining their market share and market reputation.? A strong market position can reduce risk, whereas a company in a declining market may pose a higher risk.

·??????? Reference Checks: Contact other suppliers that have extended credit to the applicant. Ask specific questions about payment terms, timeliness, disputes, and the amount of credit extended. Positive references from reputable companies bolster your confidence in the applicant’s creditworthiness.

·??????? Company Size and Order Volume: Set credit limits relative to the applicant’s size and typical order volume. A smaller company or one with limited order volume may warrant a lower credit limit. Consider the applicant’s historical purchase volumes if available, or start with conservative limits that can be adjusted based on performance.

·??????? Initial Credit Terms and Conditions: For new customers, consider starting with a conservative credit limit that reflects the above factors. Consider offering shorter payment terms than your standard terms to reduce exposure and establish a track record of payment behavior.

·??????? Adjust Dollar Limits Based on Payment Performance: Monitor the applicant’s payment history and adjust credit limits as appropriate. Timely payments and increased order volumes can justify raising limits, while late payments or returned checks might prompt a review and possible reduction.

By incorporating these factors, credit pros can set credit limits that effectively balance risk and opportunity. This approach ensures that credit is extended responsibly, protecting the company’s financial health while fostering sustainable business growth.