How to Set a Reasonable and Effective Credit Limit?
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Once you've determined that a prospective customer is creditworthy, how do you determine a reasonable initial credit limit based on the information you've gathered about the buyer?
There are three credit limit calculations that can help you determine an amount that is both fair and appropriate:
1. Net Worth Calculation: Utilizing this calculation to assess a credit limit is in your best interest because it limits your exposure, that is, the amount you have "invested" in the customer.
Calculate Net Worth by subtracting Total Liabilities from Total Assets. Both figures are found on the company's Balance Sheet.
The credit limit is then based on a percentage of the customer's Net Worth. A good rule of thumb is to limit your initial credit offer to 10% of the buyer's net worth. If you prefer, you can offer 10% of his working capital or 10% of his average monthly sales.
2. Trade Reference Calculation: This calculation can be used to establish a credit limit comparable to what other creditors and/or competitors have granted.
Calculate the median credit limit based on the credit limits offered by other creditors. If you are unable to determine these credit limits, use the buyer's recent high credit figures. These should be available on independent credit reports and by contacting the buyer's trade references.
3. Needs-Based Calculation: This calculation favors buyers and is based on providing them with a credit limit that will meet their needs relative to the terms granted. It amounts to simply giving the customer what he says he needs in the way of credit facilities.
Suggested Approach: Apply each of the three calculations to the buyer and then take an average. This should come fairly close to providing a reasonable credit limit. You can then decide to raise or lower the limit based on any previous experience with the buyer, credit and trade references from other sources, suits or liens against the company, age of the financial information, and the current economic conditions in the buyer's industry and country.
Note: Once you establish a credit limit, don't treat it as if it were written in stone. You should consistently monitor the customer and, based on changing conditions and your ongoing experience, adjust the limit as necessary.
