When it comes to setting customer credit limits it’s important to remember that the goal of a credit limit is not to prevent customers from buying more, rather to maximize the relationship while taking care to reduce credit risk in the process. They key to setting smarter credit limits to enhance both customer relationships and cash flow is about finding the balance.
The idea is simple, good customers with established credit should have access to more credit to buy more product and services. New or financially unstable customers should have little to no credit until their financial situation stabilizes. While the logic here is simple, calculating what a customer’s credit limit should be is a little more complex. Before we show you how to calculate customer credit limits, there are some things you must keep in mind:
Although you want to build relationships with your customers, you’re a business, not a bank, and protecting yourself against credit risk should be a priority if your customers are not paying on time.
If a customer who has historically paid on time comes to you and requests an increase in their credit limit, consider the risk of not extending their credit. They could easily go to your competitors if they are offering them more credit. That doesn’t mean say “yes” just because they asked, but consider what would happen if you said “no” before you respond.
Make sure to review customer creditworthiness frequently, and don’t be afraid to make adjustments if their credit score or payment behaviors make it necessary.
HOW TO CALCULATE CUSTOMER CREDIT LIMITS TO REDUCE CREDIT RISK
THE NET WORTH CALCULATION
he result of this calculation gives you a credit limit based on the customer’s net worth, limiting your risk and providing strong credit limit benchmarks based on concrete financial information. A best practice is to limit the credit offered to 10% of the customer’s net worth.
The first step is to attain the company’s financial information. This can be done by requiring them to fill out a credit application, asking for it directly, or purchasing a credit report. After receiving the information, you can work the equation:
The result will be 10% of the customer’s net worth and a good benchmark for setting their credit limit. You may also consider basing their limit on 10% of the customer’s working capital or average monthly sales.
TRADE REFERENCE CALCULATION
As mentioned in the previous section, trade references can be found on credit reports or by contacting the references provided by the customer on their credit application. This will give you an idea of how much other creditors or competitors have extended to the customer, something you can mirror if it seems fitting. Another way to use trade references to set credit limits is by finding the median value offered by other creditors, and use that as a starting point.
How much credit did your customer ask for? While you do not need to blindly offer them what they ask for, taking it into consideration is vital to ensure you’re offering them a limit to satisfy their needs; an important part in building a lasting relationship with the customer and making sure they don’t leave for a competitor who will offer them more. At the same time though, make sure you are careful to investigate their creditworthiness before extending them the terms they have asked for- sometimes losing a customer with bad credit is cheaper than extending credit to a customer who doesn’t pay on time.
While these are separate calculations, it is considered a best practice to find the average of all three of the above calculations, and use that as a starting point. Once you have that average, you can raise and lower the credit limit based on other information you have on the customer through previous experiences or information from other sources.
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