Why set up credit limits?

One of the more frequently asked questions I am always asked is how to set up credit limits. However, before the how, the more important question is why set-up credit limits. Credit limits serve as an estimated ceiling that represents the judgment of the creditor as to the amount of credit, which may be extended safely to an existing debtor or credit applicant.

Credit limit is the product, produced by the in-depth analysis of the various elements and basis of credit in relative proportion to the credit applicant’s needs, capability and capacity to pay within the credit term extended. As a standard practice credit limits represents the maximum allowable amount that can be extended to a certain client. This is arrived more or less from the viewpoint of the creditor and sometimes from the debtor. An effective credit limit serves to improve the granting or establishment of credit in particular transaction for credit promotion and efficient collection.

Furthermore, credit limit works also as a guide in the promotion of sound credit operations, not withstanding the fact that, credit limits are restrictive by nature. It opens the opportunity for repeated customers business as they proved themselves capable and worthy of more credit extensions.

It is highly advisable and recommended to discuss and share the credit limit information and how it was arrived with the sales/ marketing group to have a more effective sales/marketing-credit operations relations, thus avoiding wasted sales efforts and expense in getting orders in excess of the customers’ limits which in the end will be rejected.          

Credit limits are oftentimes interpreted, as the maximum amount of credit the company is willing to extend, the ceiling above which the risk is too great to accept. Used in this way, the credit limit is usually called a credit line.

In a company, which generally uses credit lines as guides for order processing, a limit may come to be used with certain accounts; for example, a customer may be assigned a peso credit line close to his normal purchases. His purchases increase, eventually reaching a point beyond which the credit executive considers the risk too great. A limit has then been set on the account. Similarly, the customer's financial condition may deteriorate to the point that the line formerly used as a guide is considered the maximum amount of credit to be extended.

Administration of credit lines of any kind requires that there be available accurate and efficient record of unpaid invoices and orders approved for credit unshipped. The form and detail of this record vary according to the kind of control that is wanted. Proper enforcement of a credit limit demands a record that is complete, detailed, accurate and thoroughly up to date.

 Overall, there are four advantages of setting up credit limits: First, it is a reliable tool for the control of credit extension and promotion of sound credit practices that will result to the effective collection of accounts. Second, it prevents misunderstanding and confusion within the sales operations and with the customers and provides some degree of discretion for automatic control over the accounts receivables. Third, it aids in reducing the cost of credit and collection operations and contributes to its efficiency. And lastly, credit limits works as a check and balance against imprudent or reckless buying of customers on credit.

For more credit & collection (C&C) questions, comments and rejoinders you want to share or inquire, you can reach me at 0917-7220521 or at [email protected]