For many small and medium-sized enterprises, the ability to extend credit to customers has the potential to open up new business opportunities. However, by opening to these commercial opportunities, businesses expose themselves to financial risks. Too many SMEs struggle with poorly managed credit, leading to late payments, defaulted payments, bad debts, unnecessarily high accounts receivable, and financial instability.     

Understanding how to calculate customer creditworthiness, set customer credit limits and apply them forms the cornerstone of good business practice. 

Learn about the importance of customer credit management and how we can assist you in confidently offering credit to your customers.

  • One of the potential advantages of customer credit is that it builds sustainable business relationships
  • Before extending credit to your customers, identify their creditworthiness
  • Setting an appropriate credit limit is essential
  • Different types of credit can be offered to your customers 

When we talk about a customer’s “creditworthiness”, we are referring to their ability to pay. Before you even consider extending credit to a customer, you need to investigate their history of paying on time and anticipate their ability to continue to do so. 

By calculating your customer’s creditworthiness, you can build a reliable picture of their financial health and the likelihood of you being paid back. This involves investigating their past record of being a good payer, their past and present debts, their cash flow, and their likely ability to pay in the future. One of the best ways to gauge a customer’s creditworthiness is to apply the “Five Cs” of creditworthiness: capacity, capital, collateral, conditions and character. We explore how you can use the Five Cs to carry out a customer credit check in more detail here.

Once you have decided that your customer carries a good credit risk, you need to decide how much credit you want to offer.

Calculating the appropriate credit limit for a customer is essential. There are three standard ways of calculating appropriate credit limits: 

Trade references are testimonies provided by other industry partners as to your customer’s past payment history. They provide details of past transactions with your customer and can be found on credit reports. Customers may also proactively provide contact details of references to be contacted in support of their credit application. Customers with good trade references are more likely to get better credit terms than those with more mixed references.
Another way to set a credit limit on a customer is to calculate it as a fraction of their net worth. Their net worth can be calculated on the basis of their total assets minus their total liabilities – information which can be found in their credit application. A good benchmark is to set a customer’s credit limit at 10% of their net worth.

The third way to calculate a customer’s credit limit is to take into consideration the needs they express. By identifying their needs and extending credit to enable them to meet those needs, you are laying solid foundations for a healthy and sustainable relationship.

Each of these three calculations may come up with a different figure and best practice dictates that you should calculate all three and take the average when setting a customer’s credit limit.

Once you have calculated an appropriate credit limit for your customer, you need to consider what kind of credit you are prepared to offer. There are three types of credit you could consider extending to your customers. Each has its strengths and weaknesses.
Setting up an instalment credit account for your customer is one of the most transparent ways of extending credit to them. You effectively “lend” the customer the funds to make their purchase, on the condition that they repay the purchase in fixed instalments at set points in time. The advantage of this option is that both parties are aware of the amounts to be repaid and the time scale over which the balance is to be settled. 
A revolving credit account sets a maximum limit on borrowing and acknowledges the fact that the borrower has a variable income. A revolving account offers the borrower an open credit line, up to a set maximum. The borrower repays the credit fully or partly, and on an ongoing basis they can make use of the credit facility up to the credit limit. As long as the borrower’s account remains in good standing, the revolving account can operate indefinitely.

A vendor account (also known as a “trade” or “supplier” account) allows a business to pay for products or services over a set period of time and up to a set limit. The total outstanding amount must be paid within a fixed period of time, usually 30 days (such accounts are referred to as “net-30 accounts”). 

Vendor accounts can be an effective way of building trust between you and your customers. You should be aware, however, that there is always the possibility of a vendor account being abused by the borrower and should take appropriate precautions to protect yourself against this possibility.

Credit limits are never set in stone, and you must review them regularly to ensure that they continue to meet your customer’s needs while protecting yourself from unnecessary risk.

However, your customers may find themselves going through a difficult period or may wish to expand, and the terms which were originally set in your credit offer may no longer be sufficient. They might approach you seeking for an extension to either their credit limit or the period of time they have to repay it.

Increasing a customer’s credit limit can help them weather the storm and can consolidate your business relationship. However, it shouldn’t be undertaken without an in-depth analysis of the customer’s financial situation.

Another important advantage of allowing your customers to use credit is that such sales do not normally incur interest, unlike borrowing from a bank or other financial partner. This makes the option less costly for the customer and simpler to calculate all round.

Despite these advantages, do bear in mind the fact that extending credit is inherently risky. And when increasing credit limits, it is crucial to adopt a suitable risk management strategy. In your enthusiasm to build trusting and sustainable relationships with your customers, be careful not to miss any red flags which may indicate that serious financial difficulties are on the horizon.

Extending credit to your customers can be a great way of building trust, loyalty and mutually beneficial business relationships. However, it does involve risk to your business. This risk can be mitigated through careful financial analysis, monitoring and adjustment.

At Allianz Trade, we can help you build sustainable, healthy financial relationships with your customers while protecting you from unnecessary risk and stress.