Written by Marc Bishop
Posted on 29/08/2017

How to set credit limits

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Credit control – the process of ensuring the right credit limits are extended to the right customers – is a critical and complex part of business management. Done successfully, it can help you maximise sales opportunities while protecting your business from late payment and bad debt.

Numerous factors contribute to effective credit management. Here, we explain some best practice techniques for setting credit limits.

Know your customer

Also called KYC, ‘know your customer’ is the process of assessing your prospects’ and current customers’ creditworthiness. Effective KYC requires your business to have a robust due diligence system in place. It involves everything from verifying contacts to ensuring your customer isn’t on an official trade blacklist.

In the case of large corporates, this includes verifying the company’s full name, company registration number, the registered office in the country of incorporation, plus the business address. For private or unlisted companies, this includes verifying names of all directors (or equivalent), plus the names of individuals who own or control over 25% of its shares or voting rights. Finally, the names of any individuals who otherwise exercise control over the management of the company should be gathered.

In order to verify electronically provided or copied identity documents, it’s advisable to invest in the services of a reputable third party, who can carry this out for you.

Analysing financial statement

The credit limits you set should be carefully tailored to your individual customers, which means understanding their business needs and capabilities. You should undertake a rigorous assessment of the company’s financial status and circumstances to ensure they can safely meet the agreed payment terms. A credit risk management service can help you do this by utilising big data analytics to rate your overall risk, predict the risk of a customer’s business failure and detect positive or negative payment, sales and business trends. 

It’s also crucial to understand a customer’s sector-specific risks and opportunities. Do they operate within a volatile sector or geography? Are they vulnerable to political changes? What is the long-term performance outlook for their industry? Assessing this data will provide you with valuable insight that helps determine your credit management decisions.

Customer scoring

Once you’ve established the above information, it’s useful to adopt a customer scoring process to help you set optimal credit limits. Your customer base will consist of a range of clients – from those who place frequent orders and make up the bread and butter of your business, to those who make one-off orders of varying sizes. By segmenting your customers into different categories, you can set productive credit limits, manage these relationships more effectively and create credit processes that support better revenue generation.

Once you’ve categorised your customer base, you can attach suitable procedures to each group to ensure you’re approaching these relationships in the best way. You may give those with higher scores a more flexible payment process, or set stricter repayment terms to those with lower scores. And remember to review your customers’ score on a regular basis as they may have improved their finances and payment times. It’s important to move customers into different segments or create different categories as your model evolves.

Risk policy

Policy adoption is critical though and needs every department’s buy-in. Nothing is more frustrating if, for example, the credit department agrees on £10,000 credit when the sales department have an order for £20,000. Due diligence is the responsibility of all and, in that respect, expectations have to align with what is best for the company whilst achieving what is required (i.e. a good sale that is profitable and paid on time).

Setting credit limits calls for flawless due diligence and regular assessment to ensure you are maximising opportunities and minimising your risk exposure. To find out more about setting credit limits, download our Understanding Credit Risk for Dummies guide or read about our solutions.