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 economic situation recently has seen a resurgence in the need for organization-specific credit limits, and the necessity of reviewing and adjusting them as circumstances change.
Here are some suggestions for setting credit limits.
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.
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
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.
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.
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 way to set credit limits. 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 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.
Leveraging Tools and Technology to Monitor Credit Risk
Monitoring credit risk is done more efficiently and effectively with automated credit and collection solutions. Sage AR Automation has a number of solutions which can help you monitor credit risk including:
- Custom Credit Scoring Model: Calculates credit score based on values and weighting assigned to factors you think are the best indicators of your customers’ credit quality.
- Dashboard Reporting: With a glance your team can see a customer’s account status, custom credit score, days past due, available credit, D&B, Experian, TransUnion; and whether the account usually pays on time or late and by how many days.
- Automated Customer Communications: Automated emails or text reminders based on the status of customer invoices.
- Activity Management with Smart Activities: Prioritizes activities for your team based on account information.