How does your company’s credit administrator determine if a customer should have $5,000 credit, $10,000 credit, $25,000 credit or more? Too often, customer credit limits are set based upon how much product a customer intends to buy, not by their creditworthiness.
To make reasonable and accurate credit amount decisions, credit staff need detailed customer information. This should include financial statements on any customer requesting $10,000 or more in credit.
If presently you do not require financial statements and it appears highly unlikely to you that your customers will provide financial statements, consider this — Would a bank lend your customer $10,000 without seeing any paperwork? Then why should you?
If you are not getting financial statements, first institute this requirement for any new customers. For existing accounts, you may want to set a higher dollar amount of credit than $10,000 (for instance $25,000). A friendly letter from the company president explaining the new credit policy and requesting financial statements from the current customers usually works well. Follow-up calls can be made to companies that don’t respond in a timely manner to the letter.
Once you have financial statements in-hand, what do you look for to actually establish a credit limit? The answer is CASH! Cash is the only thing that pays your invoice. Use the following dollar limitations when setting each customer’s credit limit:
1) The average combined cash balances in all checking and savings accounts plus available unused lines of credit. When checking bank references, ask about any limitations on credit lines (such as receivables and inventory balances) to be sure the company can access its entire line amount.
2) All cash balances plus available credit lines plus accounts receivable minus all trade payables. (Leave inventory out of this equation unless it is extremely liquid.)
3) The company’s current high amount of credit (unless there is a major new contract or business expansion.)
4) The company’s net worth. Net Worth equals total assets minus total liabilities. (You don’t want to have more invested in the company than the owners do!)
If using the above guidelines you find a customer’s appropriate credit limit is less than their anticipated purchases, you must stick to your credit limit and require shorter terms. And remember, these guidelines are to be applied after determining that the customer is creditworthy.
If an account shows any of the usual red flags — NSF checks, overdrafts, delinquencies, tax liens, management problems, legal actions, frequent credit requests, losses, or deteriorating financial conditions and ratios — any amount of credit is too much! Decline the request.
