How to Determine A Reasonable Credit Limit

8 Oct

Deciding whether to extend someone credit can be a tough process and requires you to examine many facets of their business. What happens though once you decide to extend them credit? How much credit should extend? The answers to these questions will vary based on your financial situation and your customers’ financial resources and operating history but we recommend a quick low credit limit method and a need-based method

A quick method for low credit limits is to average out the credit limits your competitors offer. This information is often secured from your salesperson, trade references or credit report.

How much do they Need?

For larger credit requests you will need to do more work. Essentially, it is based on how large of a credit limit your customer needs to meet their anticipated demand. In order to validate demand and determine risk, these are some of the questions you need to be answered.
How is your product used in their business? Is it part of a product they make or do they sell your product directly to their customer? Is the demand they have based on prior history or is it based on anticipated growth or a new product line altogether?

Companies with Credit History

If it’s based on demonstrated history then you can feel more comfortable granting their credit request. If it’s for the growth of existing products or a new product and their request is covered by purchase orders or easily covered by cash flow, assets of the business or a string personal guarantee then once again you can feel more comfortable granting their request.

How to Handle New Businesses

The remaining requests (likely to be new businesses ) that have the minimal demonstrated need, profits or assets, we assume there is something in their business plan or owner history that makes you comfortable taking a risk. Setting a credit limit for this group often comes down to the financial resources and cash flow of your business. There is no exact science but one approach is coming up with three numbers for the following question. What is the largest amount I’m willing/able to lose on an A, B and C high-risk new customer? New customers have a large upside, strong business plan, and owners have proven track record in business. B and C have some lesser blend of those characteristics. Increase or decrease the amount you are willing to risk for A, B and C new customers as your business conditions change.

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