How to Set Limits When Extending Business Credit
Extending credit to other businesses can build customer loyalty, encourage clients to place larger orders, and provide a competitive advantage versus less generous suppliers. Known as trade credit, this business-to-business financing method allows small firms to purchase goods and services without applying for a traditional loan. Since many small businesses lack the credit history to qualify for bank loans, trade credit can be a lifeline for growth.
Before a business owner can extend credit, he must determine a reasonable dollar limit for the client. Since the consequences of a late payment or default can damage the lender’s own balance sheet, it takes more than a simple gut-check to arrive at this number. A supplier should first learn as much as possible about their customer, then apply a consistent method of calculating the business’s credit limit. As exciting as it may be to bring on a new customer, suppliers should manage the risks associated with extending credit.
Run a Business Credit Check
It’s important to do your due diligence on a new business customer in order to reduce risks that come with extending credit. Requesting a business credit report from Dun & Bradstreet may provide insights into a firm’s past payment history, revenue and outstanding obligations. Some reports, like the Credit Evaluator Plus™, even offer a business credit limit recommendation based on a number of factors.
Brand new businesses may not have had time to establish business credit scores and ratings. In that case, you have a number of methods from which to choose when settling on a trade credit limit. If little information is available on the company itself, you can request information on the business’s owner from a personal credit bureau.
You should establish a business credit policy in writing, and require that potential customers fill out a business credit application. Ask for trade and bank references along with financial statements. Responsible business owners should understand the need for this level of verification.
Remember that your calculations are based on certain assumptions, and there’s no guarantee that past performance will carry on into the future. Extending credit carries risks, and the main purpose of any credit limit exercise is to determine a reasonable dollar amount for a specific client.
Business Credit Limits, by the Numbers
You may be tempted to set a business’s credit limit based on the level of trust between you and the owner. Remain cautious – credit limits should be underpinned by solid data. This is important to protect your own financial health, and could be a crucial piece of evidence if a business accuses you of unfair lending practices. Federal law prohibits credit discrimination based on race, sex & age (among other factors) and those you reject have a legal right to know why credit was denied.
That being said, there are various ways to determine how much business credit to offer a new client. The techniques below represent just a few options, and your preferences may vary based on industry, access to information, and the level of risk your firm can tolerate.
Net Worth Calculation
A company or individual’s net worth is determined by subtracting the sum of their liabilities from their assets. Suppliers that rely on this method typically set trade credit limits at 10% of the borrower’s net worth. The net worth method is generally considered on the conservative side of the spectrum, as a borrower could theoretically avoid default by tapping into the value of their assets.
Trade References Model
It’s common for suppliers to contact trade references for details on the credit limits they’ve extended to a business. New lenders may average these numbers, or match the high or low limits offered by others. Verifying on-time payments can provide some amount of reassurance that you’re dealing with a reliable client. Keep in mind that this method depends upon the judgment of other business owners, and you won’t necessarily have visibility into how they set their limits or what they consider bad credit behavior.
Days Sales Outstanding (DSO)
Many businesses extend trade credit, and your potential partners are probably among them. A client who invoices their customers has to wait to collect that money, which means their liquid assets could ebb and flow throughout the month. The days sales outstanding formula divides the amount of income received versus outstanding credit, then multiplies this quotient by the days in a month. The final number is the DSO, and provides an indication of how effective a company is at collecting money owed.
A DSO above 45 may indicate a cash-flow issue, and this could mean that the client may have difficulty fulfilling their obligation to a supplier (that may be you!).
Extending the Requested Amount
Some companies simply agree to invoice the client for the amount of goods or services they request. However, lacking any firm data on a new client, the supplier is assuming all of the risk. You may have a satisfied customer, but the relationship can sour if they don’t meet their payment obligations.
How to Help Manage Your Credit Risk
Setting the appropriate business credit limits for clients can create opportunities for both of you. However, developing a business lending policy isn’t always a one-and-done affair.
Consider applying consistent risk management practices to all of your business relationships. When you see a red flag – a murky business history, liens or legal judgments, unusual references, or too-good-to-be-true terms – you may want to put on the brakes until you can get the answers you need to re-evaluate the potential credit risk.
Rewarding Responsible Behavior
Clients who pay their invoices on time are the kinds of customers with whom you want to keep doing business. Suppliers often provide discounts to those who repay their debts early, which can encourage even larger purchases. In addition, consider providing trade references** (records of past payment experiences) to the business credit bureaus. This may help a company establish or impact its business credit scores and ratings.
If you have business credit extended to multiple companies you might want to consider a risk management solution that can help you monitor the companies’ business credit for any fluctuations that might affect your business.
Photo Credit: RLTheis, Twenty20