How Much Credit Should You Extend?
The Value of Setting Meaningful Credit Limits that Support Customer Purchase Volumes
Extending credit is standard practice if you are selling to other businesses. In the world of business-to-business (B2B) commerce there aren’t many situations where you can require payment in advance or upon receipt of goods or services. Most commercial enterprises are simply not willing to continue trading without credit terms, making it difficult for any trade credit grantor to generate enough revenue to survive on cash sales.
While credit sales allow you to increase revenue, they also come with a downside. Most prominent iss the risk of being paid well beyond terms by some customers, which will impede your cash flow. Less frequent, though more painful, is the risk of not being paid in full, which will not only depress your cashflow, but also eat into your company’s profits.
Extending credit is therefore a risk versus reward equation. The questions you must answer:
How much open credit should I extend to a customer to maintain risk within acceptable levels?
And when the risk does not warrant open credit terms;
How can we structure the transaction to ensure a profitable sale?
Too often, extending credit is viewed as a yes or no function. In reality, granting credit is much more complicated. The goal is not preventing bad debt losses but rather maximizing profits. If you should try to eliminate all bad debt losses, chances are you will forego sales to customers that will eventually pay.
Aggregate Credit Risk and Seamless Trading
An important goal for your business is to trade seamlessly with your customers; that is to fulfill their orders completely, accurately and QUICKLY. This will establish you as a high quality, preferred supplier and should lead to increased sales volume and a solid relationship.
Holding orders on a customer that is over their credit limit or is past due, pending a payment that brings them back within parameters, interrupts seamless trading. Many companies set very conservative credit limits, thus creating a situation where almost every sebsequent order is put on hold pending a credit review. Besides creating unnecessary work for the person checking credit, this tactic is a brake on seamless trading.
On the one hand, controlling bad debt and delinquency losses is critical. On the other hand, how does a company reconcile seamless trading and profit optimization?
The first step is to estimate how much bad debt loss you can absorb in a year. This will determine how much credit risk you can bear and how tight your credit controls need to be.
The principal determinant is your overall gross margin. If it is high, you can bear more credit risk, since the incremental profit on a sale to a risky customer when paid, will deliver significant profit. Conversely, if the profit margin is low, bad debt losses will have a much greater impact, and credit controls will have to be tighter. The following examples illustrate the point:
A wholesaler with a 2% gross margin requires $500,000 in incremental sales to compensate for a small, $10,000 bad debt loss.
Many pharma manufacturers have a gross margin above 80%. They can sell to high risk customers, because when they do get paid, the profit they gain exceeds even a substantial rate of bad debt in the aggregate.
Understanding the impact of credit losses on your profits will guide your credit evaluation of individual customers. Nevertheless, it is also important to keep in mind the aggregate credit exposure you can tolerate. In large part, that is determined by your company’s annual revenues.
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How Much Credit is Prudent for Each Customer?
A credit limit is a quantification (in dollars) of how much credit risk you are willing to bear with an individual customer. The two determinants in setting an individual customer’s credit limit are:
Creditworthiness: How much credit can the customer handle and still be able to pay its obligations in accord with your terms of sale. This evaluation is based on their overall financial strength and liquidity. It is determined by a thorough credit investigation that includes a rigorous financial analysis.
Requirements: Ideally, you want to set a credit limit that is adequate to cover the customer’s production and/or distribution requirements so you can fulfill their orders without delay. What is the value of the customer’s estimated purchases per month? What are the payment terms?
For example, if the customer’s estimated purchases are $50,000 per month and they have Net 60 day payment terms, they are going to need at least a $100,000 credit limit to ensure no credit hold on orders. Add an allowance for order surges of 15-20% and you have a credit limit of $120,000. If they have the financial strength to pay for this volume, this credit limit will promote the seamless processing of their orders, a major contributor to a good Customer Experience (CX).
There are several ways to determine if a customer has the financial strength to support a line of credit based on their ordering patterns as was illustrated above. When customer financial statements are available, common metrics for setting a maximum credit limit involve a using a percentage of cash flow, working capital, or net worth. When financials aren’t available, the customers high credit and payment history reported in credit bureau reports or from trade references provide a guideline — if your requirements are less than those reported by other vendors that are being paid promptly, you should be in good shape.
When Credit Requirements Exceed Creditworthiness
What can you do when the customer’s credit worthiness does not support a Credit Limit that accommodates their estimated requirements?
This is where it gets tough, requiring good judgement and the assumption of credit risks. In most cases, the best solution is a lower credit limit that is monitored closely for payment performance and total exposure. If the customer pays well, you can always consider raising their credit limit. If not, keep the credit limit where it is, and continue to manage the past due and total exposure carefully.
Let’s reconsider the above example. Instead of giving the customer a $120,000 credit limit on Net 60 terms, allowing them to readily meet their requirements over a two month period, you could knock their limit down to $50,000 and shorten their terms to Net 30 days because of questions about their creditworthiness. By doing this, they can still meet their monthly requirements by purchasing $50,000 from you, as long as they pay you within the parameters of the shorter terms. If they don’t pay promptly, you simply hold their next order and limit your exposure until the customer pays.
Other Risk Mitigation Options that Facilitate Extending More Credit:
Obtain third party security on the debt owed you. This could be in the form of Credit Insurance, an Irrevocable Letter of Credit, or a third party Guaranty.
Arrange for Third-Party Financing of this customer’s Accounts Receivables (AR). Invoice financing involves selling your receivables to a third party. This type of financing provides cash flow benefits to both you and your customer, and the cost can be quite modest. Also, there are a number of fintech vendors starting to offer Buy Now Pay Later (BNPL) solutions where the supplier gets paid in just a few days while the buyer gets extended terms or is able to make smaller payments on a bi-weekly or monthly cycle - but that’s a topic for a future post.
Establish a Security Interest under the Uniform Commercial Code (UCC). The problem with financing agreements that include a standard Security Interest, is that any bank, or other third party finance firm, that provides a loan to your customer, is likely to have already perfected a security interest in their inventory and AR as collateral for the loan. In that case, your Security Interest, will be relegated to a secondary position. In other words, should your customer go bankrupt, the bank will get paid before you, and you only get a payout if there are any funds left over from the liquidation process. The way to get around that is to set up a Purchase Money Security Interest (PMSI) under the UCC.
For more information about these risk mitigation options, check out the YVCM post from September 19, 2023: “Customer Stops Paying; Now What?”
The Bottom Line . . .
Providing Credit Limits, especially for financially weak customers, involves bearing the risk of loss from delinquent payments and possible default. Even so, the incremental revenue and profit from selling to these customers can be lucrative.
There are valuable risk mitigation tools that today enable you to better control your exposure while still making profitable sales. Even so, there remains a need to set and enforce credit limits. There is no other tool as valuable as a well thought out credit limit for managing the risk/reward equation of marginal customers.