Is it possible to set credit limits more scientifically than purely using gut feel? by Kevin Ferguson, Partner
If you’re in the process of establishing a credit control process for your business, the last element you’re probably considering is how much credit to grant customers. In this article we take a look at whether it is possible to set credit limits more scientifically than using gut feel alone.
Let’s begin by confirming the steps you need to take in setting up your credit control process in the first place. This should include:
• A written statement of payment terms and conditions to be agreed with customers in advance of sale.
• A credit application form for completion by customers so that data can be collected and checked.
• A procedure for checking trade references and taking credit references in advance of granting credit.
When taking trade references ask their other suppliers to let you know what credit limit they apply to that customer. A credit limit sets the maximum level of outstanding debt that a company is prepared to allow a customer. As such it’s effectively a risk limiter rather than removing the risk of non-payment altogether.
Purchased credit limits
One way to arrive at a limit is to purchase credit limit opinions. For example, credit reference agencies will suggest credit limits that you can use for your business customers. But purchased credit limits may not be appropriate as they don’t take into account the size of your business and may end up being too high or low. So in addition to purchasing credit limit opinions there are rules of thumb that you can use.
For new customers you could set an initial starter limit at a relatively low level so that you don’t lose a sale. That would also enable you to assess the payment behaviour of that customer.
As credit limits are a risk limiter, set the limit by reference to the level of risk.
The credit reference agencies provide risk data you can take into account and a simple three way assessment might be:
a. Low risk – best payment records and credit references.
b. Mid risk and
c. High risk – customers with poor credit references, adverse county court judgments etc.
Rule of thumb 1 – SALES BASIS
For existing customers with low risk assessment, set a credit limit of double their average monthly sales. Mid risk assessment should be a month’s average sales and for high risk use Rule of thumb 2 or 3 below.
Rule of thumb 2 – TRADE REFERENCES
Take an average of the credit limits offered by the customer’s trade referees. As a variation on this include purchased credit limits in the calculation.
Rule of thumb 3 – BALANCE SHEET
Obtain a copy of the customer’s balance sheet from Companies House. Take 10% of the customer’s net tangible assets as the credit limit. Net tangible assets should be fixed tangible assets plus current assets less current liabilities less long term liabilities.
HINT If you want an average of averages you can also use all three rules of thumb and make the credit limit the average of all three.
You could purchase credit limit opinions from credit reference agencies but they aren’t always suitable. Instead we would recommend that you risk assess the customer and use a Rule of thumb to set the limit, such as double average monthly sales for low risk customers or 10% of net tangible assets if they are higher risk.
We hope that you find this article interesting and that it confirms how you can indeed take a more scientific approach to setting your credit limits than relying purely on gut feel! But as ever if this is an area that you would like help and advice with then don’t hesitate to get in touch with one of the team at JRW and we will be very happy to help you.