Credit limits are an essential tool for managing credit risk and protecting your company’s cash flow. Orders in excess of credit limits are automatically placed on hold for credit review. If credit limits are set too low, your team will be tied up needlessly reviewing and releasing orders. If they are set too high, you risk overextending credit. The recession caused by the pandemic is a real-life reason for the need for credit limits, and the necessity of reviewing and adjusting them as circumstances change.
Here are some suggestions for how to set customer credit limits.
Net Worth
One approach to setting credit limits is to use an amount equal to 10% of a customer’s net worth. This may not work for all customers if their financial strength will not support the credit limit needed for order volume.
Working Capital
Another approach is to use 10% of a customer’s working capital, but as with net worth it may not support the credit limit required for orders.
Average Monthly Sales
Using 10% of average monthly sales can be a good alternative, but keep in mind that it is based on past sales and may not be adequate for future orders.
Trade References
An average of credit amounts reported on trade references can be a good approach, but make sure that the limit you set is consistent with your company’s appetite for risk. Following the crowd can be dangerous, if the credit limit amount is more than your company can afford to lose.
Customer Request/Need
Customers may request or need a certain amount of credit to handle their anticipated order volume. You have to decide if you are comfortable with the amount of credit needed.
There is no perfect credit limit setting methodology. The objective is to find a happy medium between commercial requirements and your company’s capacity to absorb bad debt losses. That is why it is important to keep track of credit limits and adjust them up or down as needed.
When a customer is constantly exceeding its credit limit, it is obvious that a review is needed to set an appropriate credit limit. What is not always obvious is when it may be necessary to reduce a customer’s credit limit because of an unfavorable change in payment behavior.
Lockstep Collect has a number of solutions for tracking and monitoring changes in a customer’s behavior and credit which can alert you to review a customer’s credit limit. Conveniently displayed on a dashboard are credit measurements including:
- Days past due
- Available credit
- Custom credit scoring
- Credit scoring from TransUnion, D&B and Experian
- Whether the account pays on time or late and by how many days
A color scale of credit quality pops up when searching for a company on Lockstep Collect, and automated emails or text reminders are sent based on the status of customer invoices.
Lockstep Collect, a leader in cloud-based credit and collection platforms, provides automated solutions for managing credit. Lockstep Collect is an experienced software partner that can help you navigate the challenges of credit risk in the new normal.
If you would like to learn more about how you can benefit from automated credit limit management solutions, please contact Lockstep Collect at www.lockstep.io.
