How to Build Your Own Credit Limit Matrix?
It is not difficult to build your own matrix and incorporate it into your credit policy and procedures. A credit limit matrix can be an extremely useful credit management tool. They are not difficult to create, and can be easily adapted to a wide variety of credit environments. Most importantly, they can save time, reduce costs, and contribute to more consistent credit decisions.
The Matrix Defined
Simply defined, a credit limit matrix is nothing more than a reference table. Credit limits are associated with the intersection of two independent variables, usually some sort of risk quotient (credit appraisal) and a separate metric or basis reflecting customer capacity such as net worth, sales or high credit extended by other suppliers.
In essence, a credit limit matrix is a very basic credit scorecard. Scorecards typically have five to ten weighted variables that are added together to create a score. A credit limit matrix uses one variable (a credit score or rating) to weight the other variable (e.g., net worth) in order to generate a credit limit recommendation. Instead of using a table, you can substitute percentages with different credit score ranges to create a very rudimentary credit limit scorecard, but more on that later.
Probably the most familiar type of credit limit matrix is one based on D&B credit ratings. These were being used by credit executives long before receivables were computerized. A sample of a credit limit matrix based on D&B ratings is displayed in Table One and provides an excellent example of the correspondence between capacity and credit risk, which is inherent in the structure of D&B's traditional credit ratings.
Benefits of Using a Matrix to Set Credit Limits
Before looking into how to build a credit limit matrix, it is important to first understand the advantages of using these tools in your credit function. Knowing the benefits you can reasonably expect to realize will help in your formulation of the matrix. Here are eight key benefits that credit limit matrices provide:
1. More consistent policy decisions: A matrix provides a clear standard for setting credit limits. The benefits increase with each additional person granted responsibility for assigning credit limits.
2. Greatly reduced need for management review: With limits assigned based on a matrix pre-approved by management, there is no need for management to sign off on the credit limit. While there will be exceptions when the amount of credit required or requested exceeds the limit designated by the matrix, a well designed credit limit matrix precipitates significantly less management involvement.
3. Fewer formal credit investigations: Credit scoring matrices eliminate the need for full-fledged credit reviews. While accounts requiring limits over a specified threshold or above that recommended by the matrix should still go through a comprehensive credit review, it should be possible to approve a significant portion of your customers based on a standard predetermined by a matrix. Because you don't need to do as many credit investigations, you can devote more energy to those you must complete.
4. Shortens the approval cycle: A credit scoring matrix facilitates instantaneous approvals for accounts that meet the parameters. That fact, coupled with the need to do fewer formal credit investigations, ensures that you will significantly reduce your average approval time.
5. Lower credit investigation costs: Another result of not needing to do extensive credit checks on as many accounts, along with the reduction in management involvement, is lower costs associated with credit investigations. Because your credit limit matrix will be based on a credit score or a rating, you will only need to order full credit reports on those accounts that fall outside the parameters of the matrix; everybody else you can take care of with a less costly score or limited report containing the score you need.
6. Provide guidance for setting limits for larger companies: Setting appropriate limits for smaller accounts is relatively easy. There is less risk when lower exposures are spread across many customers, so it makes sense to just go with the recommendation provided by a matrix. When your exposure increases, setting an appropriate limit is more difficult, but here a matrix can serve as a guidepost in conjunction with a formal credit review.
7. Makes refusing credit easier: A credit limit matrix provides an easily understood standard for refusing open credit terms to unworthy accounts. By using a consistent policy standard you avoid any questions of preference or unwarranted discrimination of any sort, except financial ability.
8. Facilitates compliance: A credit limit matrix provides a standard, which when incorporated within an approval process, contributes to providing "evidence of control within the system" as required by auditors. In effect, it provides proof of the application of consistent standards for decision making. In short, credit scoring matrices save time, reduce costs, accelerate the approval process, and increase the consistency of your credit limit decisions. All of that can add up to some fairly substantial gains in receivables performance and management effectiveness.
Designing Your Own Credit Limit Matrix
Building a credit scoring matrix is not difficult. First you have to choose your two variables. Then you must fill in the table with appropriate credit limits. This does, however, require some forethought. Building a matrix that does not effectively address your credit management environment is counterproductive. If you find yourself overriding most of the limits recommended by the matrix, you are missing out on much of the anticipated benefits and you should probably take another look at its design.
As previously mentioned, you will need two variables: one that addresses the customer's capacity and another that reflects an appraisal of their credit worthiness. The metrics you will use to reflect capacity are relatively straightforward. Typical metrics related to capacity are:
- Net worth
- Working capital
- Revenue
- Average or median outstanding credit balances reported by references. (Average reported balances tend to skew higher than the associated median.)
- Highest reported credit balance. (You can also use average or median here.)
- Highest reported credit limit. (You can also use average or median here.)
- Available cash plus bank credit lines
The metric you choose to indicate capacity will depend upon what data are available, your tolerance for risk and quite simply your preference for one metric over another. For example, if you are able to get financial statements from your customers good arguments can be made for basing credit limits on either net worth or working capital. You will need to decide which is better for your company.
If you don't have access to customer financial information, you will probably base your measure of customer capacity on their credit references. Here your tolerance for risk can play a part. Going with median credit balance is a more conservative choice compared to using the highest reported credit balance.
Keep in mind, however, that using a median or average may require more work as opposed to a "highest reported." You can always use smaller limits (or percentages thereof) relative to the metric chosen to reflect capacity to render more conservative limits.
Creditworthiness
The measure you choose relative to creditworthiness should also be consistent with your business environment. Keep in mind that a credit bureau rating or a generic score supplied by a credit bureau are designed to apply to the entire universe of commercial enterprise. More and more, ratings and scores that are industry specific are becoming available, as are scores designed to rate just small businesses. Likewise, for public companies, you can always rely on the investment industry's rating agencies' ratings. The key is to get a good fit, and that can require segmenting your customer base and using multiple credit scoring matrices.
After you determine your two variables, you simply list one horizontally and the other vertically. Practicality will determine which one defines which axis. Taking a look at tables one and two, you will note that capacity and credit appraisal are reversed. The decision on how to lay these tables out was simply based on ease of use.
As you begin filling in the matrix with credit limits, there are a couple of things you should keep in mind. First, it is a good idea to equate the credit limits as rough percentages of the capacity metric. In other words, if you are using high credit reported as your measure of capacity, you should use roughly the same percentage of high credit for each risk classification.
Table Four provides an alternative approach, with the same results as a credit limit matrix, and provides a good example of how percentages can be used to determine credit limits. Once you have an idea of what you want your percentages to be, you can begin filling out the matrix with credit limits.
As you do so, you need to make sure the credit limit sequence is consistent both vertically and horizontally. You can see this in tables one and two, in that the limits move from high to low from both top to bottom and right to left with relative consistency.
Uses of Credit Limit Matrices
While credit limit matrices are relatively unsophisticated tools, they can be used in a variety of ways. There most common use is in conjunction with new account set-up, but they can also be used with account review by helping to identify exceptions (too low or too high limits). In addition, if the matrix itself is hard coded into the software running your receivables process, you can then automatically set limits, release or hold orders, and monitor changes in assigned credit limits.
As previously mentioned you might even want to use multiple credit limit matrices if you are selling to more than one type of customer or selling product lines with a wide range of gross margins to different sets of customers.
Another reason for using more than one matrix is if you are not always able to get the same data on each account or prospective customer. For instance, you might prefer to use net worth or working capital as your basis reflecting customer capacity, but for those accounts that will not provide financial statements you could create a second matrix (or set of matrices if you are dealing with multiple credit environments) based on credit limits or high credit balances reported by the account's references.
Essentially, a credit limit matrix supplies a standard that enables you to initiate portfolio monitoring activities. The ability to measure all the accounts in your portfolio against a consistent standard will enable you to begin ranking your customers. When you can do that, you will gain a much better understanding of your receivables.
