Once you've determined that a prospective customer is creditworthy, how do you determine a reasonable initial credit limit based on the information you've gathered about the buyer?

There are three credit limit calculations that can help you determine an amount which is both fair and appropriate:

To assess a credit limit that is in your best interest, utilize the Net Worth Calculation. This is the calculation which most favors your interest because it limits your exposure, that is, the amount you have "invested" in a customer. The Net Worth Calculation is based on providing some percentage of the customer's Net Worth (as specified in his financial information). A good rule of thumb is to limit your initial credit offer to 10% of the buyer's net worth. Or, if you prefer, you can offer 10% of his working capital, or 10% of his average monthly sales.
To establish a credit limit that is comparable to what other creditors and/or competitors have granted, use the Trade Reference Calculation. Calculate the median credit limit from the credit limits of other creditors. If you can't get their credit limits, use their recent high credit figures. These should be available on independent credit reports and through contact with the buyer's trade references.
To determine the credit limit that will meet the customer's needs relative to the terms granted, utilize the Needs-Based Calculation. This is simply giving the customer what he says he needs in the way of credit facilities.

The best approach to utilizing these three calculations is to determine each amount and then take an average of the three, providing what could be a reasonable credit limit. You can then decide to raise or lower it based on your previous experience with the buyer (if any), credit and trade references from other sources, suits or liens against the company, age of the financial information, and the current economic conditions in the buyer's industry and country.

Most importantly, once you establish a credit limit, you shouldn't treat it as if it were written in stone. You should consistently monitor the customer and adjust the limit as necessary, based on changing conditions and your ongoing experience.

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Information provided by ABC-Amega Inc. Since 1929, providing first party accounts receivable collections outsourcing and third party debt collection for management of your commercial receivables portfolio.