Best practice for setting credit limits
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Best practice for setting credit limits

Extending credit is a critical part of business – it allows you to increase your sales and grow your revenue more efficiently. But it also requires careful judgement and fine balance to ensure you have enough working capital to operate effectively. Indeed, striking the right working capital balance is crucial to your company’s health; lending to the wrong customers can lead to bad debt and jeopardise the stability of your business. On the other hand, extending too little credit means you may miss out on profit. We’ve put together our best practice tips for setting the right credit limits.

Establishing context

As a credit manager, you want to open new accounts to support your company’s financial health. If you’re dealing with a new client, or even an existing client with changing requirements, it’s important to research their company and ask the following questions:

  • Are sales and profitability figures trending up or down compared to the last three to five years?
  • Is the industry thriving, with potential for future growth?
  • How reputable and experienced are the directors?

Each of these answers should help provide clearer context with which to assess the company. Sales and profitability are key markers when it comes to setting credit. To gain an accurate picture, you need to look at the current figures compared to the previous three to five years so you can identify performance trends.

Similarly, you should also compare the company’s past and current performance to other similarly sized businesses within the industry – this will provide a useful picture of how its success should be measured. For example, are the company’s performance trends stronger or weaker than competitors? To what extent does this impact the context of its recent growth? It’s also important to think about the future prospects for the industry. Is the company likely to be affected by socio, economic, technological or political impacts and does it have a strategy in place to manage these changes?

And don’t forget, a director search can also reveal valuable insight into a company – from its organisational structure to its culture and the level of expertise with which it’s being run.

Establishing your risk appetite

Once you have developed richer context with which to assess the company and understand its performance, you can then consider your risk appetite. 
As a credit manager, you will have your own risk parameters within which to operate, but you need to decide which end of the spectrum is appropriate for each customer. 
It’s important to consider how large a supplier you want to be to this company, in light of its performance and stability. Would you rather establish a larger contract with one company or a number of smaller contracts across the industry? Conducting effective due diligence will leave you better equipped to make this decision.

Investigating purchase patterns

When setting a credit limit, it’s important to establish a clear picture of the customer’s purchasing patterns, particularly if you’re dealing with an existing customer with a change in request. As a credit manager, it’s your responsibility to fin.d out why the credit request is changing and the implications of this.

Firstly, ask the customer. Secondly, do independent research to verify their rationale. It may be that they have just won a new contract or their business is going through a growth phase. Your colleagues in the sales department should have good insight as they are typically closer to potential and current customers. And you can also draw on contacts within the industry as they may be able to provide additional insight.

Speaking to the competition may seem counterintuitive, but sharing knowledge about customers works in both your interests. For example, a competitor may reveal that a customer is typically late or punctual in repaying credit. This in turn may influence the strategy you employ in setting a credit limit and pursuing payment. 
You can even take this further by learning about your customer’s supply chain. Understanding the financial health of your customer’s customers will provide you with valuable knowledge about the security of your loan and help you avoid credit risk.

Utilising credit reports

Supplementing your own due diligence with insight and analysis from a reputable credit reporting agency can provide you with extra security and enable you to make more accurate credit decisions.

Drawing on their extensive data across different businesses and industries, a good credit reporting agency will utilise sophisticated scoring and analytics to rate your overall risk, detecting unusual patterns in a company’s activities and predicting the risk of business failure.
With access to the above tools, if you take a holistic approach to credit management you should be well positioned to set accurate credit limits that support the success of your business. In combination, strategic analysis, due diligence and technological insight are your three pillars. And remember, setting a credit limit isn’t a one-off activity – evaluate your customers on a regular basis to ensure you’re making the most of their business while protecting your own. 

To get the latest insight on Credit Risk, visit our download centre, where you can download our guide: Understanding Credit Risk for Dummies.

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