Alpha & Leader's Best Practices in Credit Management “Setting Credit Limits”

Alpha & Leader's Best Practices in Credit Management"Setting Credit Limits"

By Bobby R. Rozario

The Myth

Over the years, I suspect one of the most asked questions on risk management is associated with setting up credit limits in commercial credit. This issue has perplexed many credit management practitioners for years. The mixture of technicality and sensitivity has made practitioners experience immense difficulties in applying the theory in daily operations. The myth seems prevalent that risk management measures only play a part when risks arise.

In an era with a globalized economy, no business can seek development on its own without considering the conditions of its suppliers and customers. When it comes to applying risk management theory, neglecting dynamics in risk management and failing to formulate relevant and accurate policies lead to rigorous consequences. Before applying the concept, we need to have a comprehensive understanding of our business, changes in the market,  customer segmentation, industry, products, services details, and organizational culture. Versatility is crucial to successful applications. There is no shortcut.

The Theory

01 Setting Credit Exposure

While the concept of Credit Exposure has existed for decades, the application and its link in setting credit limits have not been widely adopted.  Credit Exposure is defined as the sum of credit limits made available to existing customers in an organization. As it is named, it is the total Exposure or "risks" to which a company is exposed to operating its business.

Example:

What is the "best possible Credit Exposure" of Company A if its annual sales target is $ 12 million?

Why should Credit Exposure be considered in commercial operations? An organization's sales target is always related to Credit Exposure unless sales are only cash basis. If not, an organization would strive to keep its Day Sales Outstanding (DSO) closely resembles its Credit Term. A large deviation between DSO and Credit Term would always lead to the draining of cash flow in its operations. On the other hand, setting a higher credit limit for individual customers essentially means higher risks. Therefore, the theoretical approach on setting credit limits always leads to targeting a Credit Exposure to its lowest level against the Sales Target. Conceptually the method is incontestable; in practice, Credit Exposure is commonly constrained by the "Target DSO". If a company's Credit Exposure is "zero" (the absolute lowest level), it means that its "Target DSO" is at zero-days, which does not resemble a credit sale. 

Credit Exposure is proportioned to three essential objective elements; Target DSO, Cash Flow Availability and Sales Target. Although Target DSO and Cash Flows Availability are elements that directly affect the level of Credit Exposure, insufficient Credit Exposure will vary the third factor's realization, i.e., achieving its Sales Target. Thus, a strictly theoretical approach to keep Credit Exposure at the lowest level is not recommended. On the contrary, an opulent exposure level is essential to promote business development at a healthy level. On many occasions, well-experienced practitioners would design a strategy to help Sales function reach its target by incorporating a "Best-Possible Credit Exposure".  

02 Confirming a Target DSO

Target DSO may not be necessarily identical to the "Credit Term" although most practitioners hope to control it as close as to each other. Below is an example of how our Target DSO change will affect the level of our Credit Exposure.

Example:

Company A's annual sales target is $ 12 million (i.e., $ 1 million per month) and the credit term is 30 days. Take April for example. On April 30, Company A would send customers statements of account incurred from April 1 to April 30, and customers are to pay before May 30.

If Company A realizes another sales turnover of $ 1 million in May, on May 30, its pre-set Credit Exposure should not be lower than $ 2 million to ensure regular operations.

The above example has taken the assumption that the best scenario would happen to Company A; that is, every customer has paid within the agreed credit term. However, in reality, customers may default on payment and your Target DSO would primarily be influenced by the availability of your own working capital.

Suppose Company A's Target DSO or the so-called "Bearable DSO" is 60 days versus the 30-day credit term to maintain regular operations. In this case, its Credit Exposure level has to be $ 4 million (Target DSO is twice the level of credit term). In other words, the Credit Exposure should increase accordingly when the actual DSO extends by 30 days, although the overall credit risk level may become higher.

If we further assume seasonal factors would affect business transaction level, revenue turnover may exceed $ 1 million for some months. In this case, Credit Exposure may additionally need to be increased by, say 20% (or different percentages for some industries).

In conclusion, the "Best-Possible Credit Exposure" for Company A should be $ 4.8 million to maintain regular operations. In my experience, Company A's credit team should recommend a Credit Exposure in the proximity for $ 4.8 to 5 million with Target DSO at 60 days.

The Reality

When clients asked me how Credit Limit for the individual customer is to be set, I always reply with three questions to stimulate ponders；

1. What's your company's annual sales target?

2. How much are you willing to let your customers occupy your working capital?

3. To what extent will your company involve in fostering new business opportunities?

Credit practitioners and business owners often forget to evaluate these questions before giving out credit limits and leading themselves into serious cash flow issues.

Credit Exposure is interpreted as a risk since, theoretically speaking, every customer may use its entire credit limit through a single transaction and then fails to repay. Therefore, practitioners must set Credit Exposure with due consideration of the company's working capital. As I have stressed earlier in this article, a well-experienced credit practitioner would design a strategy to help Sales function foster business. A simple deduction is that companies with substantial working capital and a reasonable profit margin can adopt higher credit limits and accept longer DSOs for the individual customers than the market's average level. This approach is conducive to striking competitors temporarily and aid in expanding market share. I suggest credit managers pay extra attention in action. If used properly, this strategy helps increase cash flow availability, if not just revenue.

In summary, the basic principle in setting credit limits for the individual customers is keeping correspondent to the Company's Sales Target, Cash Availability, Target DSO and their relations to Credit Exposure.  The overall approach is always in sync with the company's overall Sales Strategy.

The Policy

03 Allocating Credit Limit Reasonably

In the ordinary course of business, Sales functions would always see the necessity of adjusting individual customers' credit limits. In most cases, Sales and Credit functions when allocating credit limits would consider the customer's desired transaction size as a priority, if not just examining its creditability. For customers with good creditability, sales managers tend to provide higher limits. However, on many occasions, Credit functions do not respond swiftly enough when adjusting credit limits.

As credit managers, have you ever not adjusted the customer's credit limit for convenient reasons? Does your credit policy allow over-credit limit transactions? If yes, how are risks managed?

Credit-Limit Adjustment has been one of the most ignored procedures in the commercial sector. The more adopted standard is to seek special approval when over-trade happened. One of the main attributions is practitioners' failure to comprehend the mechanism to fulfill the task. Below is an illustration of how such a mechanism is put into action.

Illustration:

Company A's annual sales target for the coming year is $ 12 million. The company's unified credit term is 30 days. However, considering the possibility of the average actual DSO being extended to 60 days, the Financial, Credit and Sales functions after discussions have determined that the Credit Exposure level should be set at $ 4.8 million.

In the ordinary course of business, Jamie, Sales Manager of Company A, has noticed that the credit limit of $ 100 thousand for Customer B is insufficient. After consideration, Jamie determined to double the credit limit for Customer B. However, Jamie has opted for over-limit transaction approval for years if it happens.

Reasonably allocating credit limit is the second principle in setting credit limit. Under the general rule of thumb, "any increment of the credit limit in a customer would require a decrease of the same amount in another customer to maintain the same level of Credit Exposure." Therefore, in constant circumstances, an increase in a single customer's credit limit without reducing the credit limit of other customer(s) or adjusting the relative ratio would increase the level of Credit Exposure.  Failure to comply requires an increase in Sales target to balance out the organization's risk level.  

Recommendation:

For credit managers of Company A, I would recommend a standard in the Credit Policy.  To not reduce credit limits granted to other customers, Jamie needs to adjust her Annual Sales Target to $ 12.24 million in proportion presuming the DSO of a grade A customer like B is the same as the credit term, which is 30 days. Or require Jamie to trade-off credit limits among customers.  The trade-off of credit limits should be encouraged. It helps move Credit Exposure to better and healthier usage.

In some cases, the Credit Exposure level might not tend to set at its maximum level; thus, an immediate adjustment may not need to be made for a corresponding customer. As a Policy, the standard should be well documented and uphold when required. It is always recommended that a Credit-Limit-Adjustment mechanism is essential to be put in place to manage risks effectively to avoid abusive applications. Credit practitioners should not focus on maximizing the credit limit for all customers to increase sales; instead, credit limits should only be maximized for customers with selection to increase profit. Granting credit arbitrarily to the general population among your customer profile is no more than a tactic for achieving short-term goals.

In conclusion, credit limits should be allocated efficiently. Adjustment of credit limits is an essential mechanism to foster proper and healthy usage of limits. The practice of enabling over-credit limit transactions increases risk level and applications should be handled with extra caution.

The Relevance

04 Assessing Credit Utilization Level

Besides setting Credit Exposure and reasonably allocating Credit Limits to each customer, assessing the Credit Utilization level among the overall receivables helps alert risks.

Illustration:

Let's take Jamie's situation as an example again.

It was a good year for Jamie and she has achieved a sales level at $ 10 million in the first three quarters. Everything is right up to her plan and she is looking at overachieving her Sales Target for the year. Except that she knows Eric, the National Credit Manager, is after her about the trade-receivables situation. The aggregated unsettled limits granted up to the third quarter is $ 3.5 million. It is approaching the Credit-Utilization-Alert-Limit, which is set at $ 3.8 million in the credit policy. If she fails to recover some large receivables in the next few weeks, Eric may impose a "special sanction" on all of her sales, i.e., she would need to get approval for every credit sale she makes. The Credit Utilization level has reached a Caution Level, the second-highest level, which has fallen into the "danger zone" criteria.

Credit Utilization is a critical concept in managing credit limits. Organizations with sophisticated risk management capability would incorporate the idea of "danger zone," which is mostly set in a percentage against the Credit Exposure. In general, a sanction procedure would be adopted to moderate risks when the utilization level has reached the danger zone.

Jamie knows that the danger zone level is pre-set at 80% against the Credit Exposure level. The outstanding receivables might fall into the current or 30-60 days bracket; its relevance is the amount but not the duration. Jamie has reached $ 10 million in sales, but $ 3.5 million is still outstanding. Its utilization level is approaching $ 3.8 million, which will fall into the "danger zone" bracket in the credit policy. Jamie's only way to continue to extend credit is to select customers who would pass the "special sanction" imposed by the Credit function.   

Sales and Credit managers should pay close attention to the progression of Credit Exposure and receivables recovery. How is the utilization allocated? Are most of the utilizations associated with the same customer or the same group of customers? How much of the receivables have fallen into the above-average-DSO bracket? Are you expecting a large payment soon? Getting answers to these questions would help guide you in making the right decisions.

The End of the Beginning

There are always opportunities when crises exist. For example, during the COVID-19 pandemic period, businesses with substantial cash flows can reasonably repeal the alerts, which in return may promote sales and profit. Moderating risks can be given priority to customers with good credibility and solvency. This strategy can keep loyal customers and increase market shares. Practicing credit management is an indispensable catalyst in financing commerce. It increases buying power of your customers. Grasping the necessary knowledge and skill in mastering the use of credit limits will perfect your outcome.

Remember: "Managing credit risks is an art, not a science."