Why is important to set credit limits to customers?

A credit limit defines the maximum amount of credit that you are willing to grant a customer without the necessity of completing the approval process on a continual basis.
With careful analysis, establishing appropriate credit limits will minimize risk exposure while maximizing revenue and cash flow. On the other hand, the sales process will be more efficient by reducing, or eliminating the time required for credit approvals.
From the creditor’s perspective, there are some determining factors that will assist in setting credit limit amounts:
What is the short-term and long-term demand for your product?
How is your business positioned in relation to the competition?
How much working capital will be made available for the purpose of extending credit to customers?
What is the customer’s financial strength?
What length of credit terms will be in place and how do those terms relate to the credit amount?
Generally, there are two main steps in the credit limit determination process:
Identify Customer Requirements: Before considering the amount of credit to extend to any customer, you need to find out what the customer’s requirements will be. Understand the customer’s anticipated ordering plans so you can forecast the estimated sales amounts, frequency of orders and potential profit.
Assess Risk: The risk assessment process can be broken down into comparing references and financial analysis.
Compare References: A comparison of both bank references and trade references will provide useful information for assessing the customer’s current credit standing.
Financial Analysis: Analyzing the customer’s financial strength is the most comprehensive and time consuming part of the process. The level of analysis required will depend on the customer’s credit limit request. Obviously extending a greater limit warrants more information and more detailed credit report analysis. Financial analysis may include details for some or all of the following: net worth, financial ratios, short/long-term liquidity, available working capital, credit score and payment history.

Advantages of advising the customer with information about the credit limit
The opportunity to talk to the customer about the company's payment expectations and concerns
The opportunity to discuss how the credit limit might be increased in the future
The opportunity to offer suggestions or advice that may help a marginal customer to become more successful and profitable
The above reduce the chances of encountering a potentially embarrassing situation in which a relatively new customer places an order well in excess of the credit limit and the company must hold it.
Disadvantages of sharing the credit limit with the customer:
The customer may hold their purchases in an effort not to exceed the credit limit, even when the company might consider releasing additional orders on open account terms.
An applicant may be offended at whatever credit limit is assigned to the account.
There is no way to know how a customer will respond to the assigned credit limit (no matter how large or small the credit limit might be). Generally, it’s not easy to explain how and why the credit limit was set as it was.

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