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Minimizing Risk Exposure: How to Create Credit Limits

Topics: Finance, Credit & Payments, Management

You’ve done your homework. After much thought and careful consideration, you’ve decided to extend B2B credit to a new customer. Good! You’ve just hurdled the first step to establishing a mutually beneficial relationship with this customer. Next is to determine the most suitable credit limit to offer them.

Why set credit limits?

Depending on how the customer handles the revelation, a credit limit has both positive and negative repercussions. On the positive front, customers can plan their purchases accordingly. If they feel the offered credit limit is insufficient for their growing needs, a conversation can be started to discuss how it can be raised, and you can even seize the opportunity to explain how you arrived at the offered limit.

On the other end, customers may feel bad that you can only extend a small amount to them and restrict their purchases to just the bare minimum despite assuring them of a possible increase in the future.

But because you’re the creditor and there’s always the risk of a customer defaulting on their financial obligations, it’s only wise to create credit limits, especially to new customers.

  • Credit Risk reduction. Because the process of creating credit limits requires a thorough assessment of the client’s creditworthiness, it ensures a customer has adequate paying capacity to reduce your exposure to monetary and inventory losses.
  • Speedier sales process. Establishing a credit limit speeds up the sales process, as the borrower need not go through an approval process for every credit purchase they make.

How to calculate credit limits

There’s no cookie-cutter, foolproof formula to creating credit limits. It’s not an exact science. But best practices can be employed so you come up with an amount most suited to the customer’s need and paying capacity, without exposing yourself to unmitigated financial risk.

  • Credit reports. If your company doesn’t carry any data on the customer simply because you have no past dealings with them, reports from credit agencies include collected information from their suppliers to establish the customer’s paying patterns. You can also base your credit limit calculations on the credit rating the agencies assign to them. If the rating is favorable, it may be wise to extend a higher credit limit. Otherwise, you’ll want to be more careful.
  • Trade references. Trade references allow you a peek into the credit limits extended by other creditors to the same customer. Consistently high credit limits from various sellers can signal that the client is a responsible borrower. You can follow suit and extend a similarly high amount, take the lowest, or find the median – whichever you feel is right.
  • Financial statements. Financial statements help you determine a company’s financial solvency and paying capacity. Helpful information to focus on include tangible net worth (tangible assets minus total liabilities), net working capital (current assets minus current liabilities), and the debt-to-equity ratio (total liabilities divided by stockholders’ equity), which measures a company’s financial leverage. Before making any big decisions though, verify the authenticity of the submitted financial documents.
  • Past performance. If you’re in the process of possibly raising the credit limit of a client, analyzing their past performances gives you an idea on their payment habits. Do they pay on time? Or do you need to send them multiple follow-up emails to get them to settle their dues?

How Apruve can help?

As you may have surmised from the processes involved above, creating credit limits is not necessarily easy. Factor in accounts receivable management, which involves tedious procedures such as cash application and other tasks, and you’re looking at full-time staff and a dedicated department to stay on top of things.

If you’re not ready to handle all this in-house, consider adopting a credit management solution, such as Apruve, to perform credit automation on your behalf – from assessing the creditworthiness of a client to offering them the best possible credit limit, to debt collection and many other things in between.

Net terms accounts receivable

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Apruve enables large enterprises to automate long-tail credit and A/R so you can stop spending 80% of your time and resources on 20% of your revenue. We partner with each of our customers to solve their unique credit, payment, and accounts receivable challenges and build the right credit solutions for your markets, customers, and goals. 

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