HOW TO SET CREDIT LIMITS?

Credit Limits. Are threshold that a company (creditor) will allow its customers to owe at any one time without having to go back and review their credit file.  Credit Limit is the maximum amount that a firm is willing to risk in an account. 

Credit Limits helps the creditor in the following ways:

1.      It frees up valuable time for other credit management tasks

2.      It speeds up the sales process

3.      It reduces risk and improves collection activity and efforts.

4.      It is an account monitoring tool

Credit limits have also known to upset customers. Thus, the decision to communicate credit limits to your customers rests upon you. It has its advantages and disadvantages.

One important approach that credit management should take with customers who are near their limits; asking for more or with overdue amounts is that of a counselor. This is the time to collect more information on your customer or cajole them into paying overdue amounts.  Credit Limits need not be Sales Limits and should be used as a guide to enhancing profitable sales. They can be flexible and revised often. 

Issues to consider when setting Limits

The first thing that the company needs to consider is its own exposure.  What is the kind of exposure that a company can take with its customer base? Will it be a Liberal or a ‘Conservative’?

Important factors influencing these elements will be

·        The strength or weakness of ‘Product or Service’ that is being sold;

·        The degree of ‘Competition’ or ‘Opportunities’ in the marketplace; the nature of the industry that you are in or deal with- Is the industry growing or going? Your role as a supplier, especially if you are the key supplier to your customer.

·        Whether you are a ‘Secured’ or ‘Unsecured’ creditor. If there is any lien rights that you can exercise.

·        The financial strength of your customer; the information that you have or can obtain from your customer or other sources. The number of years that the customer has successfully run that particular business and the reputation carried in the marketplace, both of the business and its management. The customer’s businesses plan or blueprint to operating the business in the future.

·        The overall ‘Margin’ that the product or service contributes to the bottom line;

·        The confidence that you have in your in-house ‘Collection’ process;

·        The length of your terms to your customer because risk is directly proportional to the length of your terms 

Another vital question that senior management in the company need to answer is: How much of their working capital are they willing to employ in their customers? Often companies forget to first evaluate these questions and get themselves into a cash crunch situation. 

Methods of Setting Credit Limits

As indicated earlier setting credit limits is not a science. Although, by incorporating the process into their scoring models some companies have made it into a near science.  The starting point to setting most credit limits is the needs and requirements of the customer. What is the customer asking for and subsequently what will be the requirement periodically? If the customer is creditworthy then would you as a customer want to set the a credit limit for the customer higher than what is being sought in order to save time in the future i.e. if credit limits are to be increased later due to increased sales volume? 

The following are some common techniques applied in setting Credit Limits:

Trade References: After obtaining the trade references you can compare the amounts of the High Credits awarded to your customer.(applicant) You can choose the ‘Highest’ from the ‘High Credits’ or take an ‘Average’ or pick the ‘Lowest’.

Bank References: In doing a bank reference on your applicant find out the amount of line of Credit that was established by the applicant with the bank. If this line is unsecured then perhaps it can give you a little more comfort in setting a relatively higher credit limit for the applicant. The use of this information is rather sketchy since the banks generally are secured creditors with stiff remedies upon default.

Agency Credit Reports: Credit Agencies generally give two pieces of information that are quite popular among credit professionals that aid in the setting of credit limits.

1.      Payment Performance: This section lists the paying habits of the applicant. The information is collected from different suppliers to the applicant. You can treat this section almost like doing a trade reference. It will give you High Credits and the customer’s (applicant) payment habit in different dollar ranges. It is quite possible that the customer might be a good paymaster in the dollar range that is being sought from you as a credit limit. Thus, increasing your confidence level.

2.      The Rating: Based on certain credit and financial information obtained on the customer (your applicant), the Agencies assign ratings. These ratings can assist you in setting your own credit limits. You can map your own limit amounts against individual ratings that a credit agency assigns.

Financial Statements: Financial statements are also used in assigning Credit Limits to customers. Mainly ratios or factors like net worth and working capital are taken and trended or compared to Industry norms or standards. If a customer shows liquidity and efficiency as per industry norms then a more confident approach can be taken in setting the credit limits. One has to also consider if short-term liquidity is important or meaningful to the nature of your credit or is long-term liquidity more consequential.

For Example: Some companies will take the ‘Tangible Net worth’ [Total tangible assets – Total liabilities. From the Balance Sheet] and assign anywhere between 5% to 15% of the Tangible Net worth as a credit limit for the customer provided the customer has shown pre-tax profits. Others consider Net Working Capital  [Current Assets-Currents Liabilities] because it measures the short-term liquidity of a company.  While doing such analysis on has to also consider elements outside the domain of the financial statements before making a conclusive decision.  For example the company that is being assessed might have suits or judgments against them. On the other hand the financial statements could be unaudited or company prepared.

Another ratio that is of importance to lenders is the ‘Debt to Equity Ratio’. The ratio is typically calculated by combining noted payables and all secured debt (such as short term and long term bank loans and debentures) and dividing it by net worth. The ratio shows how the company is leveraged and illustrates the stake of the lenders as opposed to the owners. A secured creditor (like a bank) may request to maintain a certain level of Debt to Equity. Otherwise upon default such loans become payable upon demand, which could lead to sale of assets to prepayment of the loan. If this ratio is within industry norms and to the satisfaction of the secured lender then a more liberal approach can be taken in setting the credit limit for this customer. The contribution to the credit limit can range anywhere from –5% to 15% of the customer’s Net Worth.

The Days Sales Outstanding also known as D.S.O is a rough indication of the quality of a company’s receivables.  It is calculated by dividing the net receivables by average daily sales. If the DSO is in line with the norms for the industry then  a liberal approach can be taken in setting the limit for this customer. The formula that is used with DSO is that, for each day of deviation from the norm or the selling terms you add or subtract .10% of the Net Worth.

Past Performance:: Credit Limit in this case is based on the past history of the customer as per the information contained in your books. The two elements that you would consider and weigh would be the past:

·        Payment performance

·        Purchase Pattern

Need Based: In this case Credit Limits are set based on the needs of the customer. It could be set to accommodate the first Requested Credit Limit or the Size of the first Order: It should not be done in isolation but by a combination of the other methods that are discussed in this article.

In a survey that was conducted by the Conference Board one of the most popular techniques used for setting credit limits was by using the information and ratings given by credit agencies.

ECOA and Credit Limits:

In the United States of America, creditors should be aware of the provisions under the Equal Credit Opportunity Act. (ECOA) when evaluating Credit Limits. The act would particularly apply to the notification of ‘Adverse Action’. The term "adverse action" is defined as follows:

     (i) A refusal to grant credit in substantially the amount or on substantially the terms requested in an application unless the creditor makes a counter offer (to grant credit in a different amount or on other terms) and the applicant uses or expressly accepts the credit;

     (ii) A termination of an account or an unfavorable change in the terms of an account that does not affect all or substantially all of a class of the creditor's accounts; or

     (iii) A refusal to increase the amount of credit available to an applicant who has made an application for increase. The definition is further clarified to exclude from the definition of adverse action: Any action or forbearance relating to an account taken in connection with inactivity, default or delinquency as to that account.

Unless otherwise excluded, business credit grantors must give notification to business credit applicants of adverse action depending on the gross revenues of the applicant. Therefore, disclaimers in your credit application are of importance and relevance and should be reviewed by your legal counsel.

Thus, setting limits is a somewhat complex decision making model. There is no perfect way of figuring out limits nor will there be one, but within the limitations of credit management this is just one more element in the daunting challenges amidst which a credit professional operates.

Source: Creditguru.com

How to manage your purchases? Some basics!

It's easy to neglect the area of purchasing in your business. Of course you buy goods and services, but you don't always plan the purchases as well as you could. As a result, you may spend more money than they need to, buy goods that aren't of the proper quality for your needs, or choose suppliers that don't offer the level of customer service you deserve.

If you fail to devote enough attention to your purchasing, your cost of doing business could rise to an unnecessarily high level. As operating expenses increase, profit margins shrink, you would either have to live with lower profitsor raise your prices, and neither of these choices is appealing. By keeping your costs under control, you'll be able to keep your prices at competitive levels and maintain a desirable profit.

Purchasing Policies

To purchase wisely, you need to buy the right quality and quantity of materials or products at the best possible price and at the appropriate time from the best vendor.

Purchasing need not be the purchasing manager's sole duty; in fact, your business may not do enough purchasing to require a full-time purchasing manager. You should select an employee who can handle purchasing, as well as the other duties he or she my already have. This individual should be able to communicate clearly with your business's suppliers. Although purchasing duties probably won't occupy all of this individual's time, there is more to purchasing than placing orders. The purchasing manager will have to gather orders, make sure they are complete, and stay within any limits the company may have set on spending, select an appropriate vendor, order the goods, check their condition upon receipt, make sure the invoice is correct, and speed payment of the invoice by forwarding it to the accounting department.The purchasing process is much more streamlined in small companies than in larger businesses, especially when the businesses are still fairly new. The owner usually decides what to buy, when to buy, where to buy, and how much to buy. As the business grows, however, the owner may no longer be able to handle this task and will have to delegate it to others. While a small business probably won't need to create an entire purchasing department, it will need to have a purchasing manager. By selecting one person to manage all of the business's purchasing activities, you will decrease the risk of duplicating orders for the same materials.

Before you delegate the purchasing function to another employee, you should write out a purchasing policy for your business. You may even want to create such a policy while you are still responsible for purchasing, as a guide for yourself.

The purchasing policy, according to the SBA, should answer the following questions:

• Who has the authority to purchase items for the company? What items can that person purchase? Are there any spending limitations?
• What are the business's requirements for adequate supplier competition and what criteria will be used to select possible vendors?
• What is the company's position on the acceptance of gifts?
• Which types of contracts can the business enter into with successful bidders or vendors?
• What is the company's position on conflict of interest and personal loans from suppliers?
• What kinds of information does the company consider confidential?
• What is the procedure for dealing with legal questions?

The Ordering System

The steps your employees and purchasing manager will follow to request, order, receive and pay for goods and materials make up your ordering system. A good ordering system will help maintain satisfactory supplier relations, improve cash management, aid in inventory control, and increase the overall profitability of your company.

The Purchase Order

Once the purchasing manager has received a requisition, her or she will need to select a supplier and check the price of the items ordered. After agreeing on a price, the purchasing manager will send a purchase order to the supplier. This order is a formal request to the supplier to deliver materials or supplies according to the terms and prices agreed upon. Purchase orders, like requisition forms, can help small businesses keep track of their purchasing activities. Firms can refer to their purchase orders to see if suppliers have shipped the correct goods in the correct quantity. They can also see if suppliers are delivering goods on time. Purchase orders can also serve as support in any legal disputes if they arise between you and the supplier.

Although you can write out purchase orders by hand, you would give a better impression if you used standard multi-part forms that you can purchase at any stationery store. They should include information such as the type of product or service you are ordering, the quantity desired, price and delivery terms. The orders should also have an area for any additional information. Purchase orders should also include your company name, address, telephone and fax numbers, and logo. You can simply write in this information, stamp this information on your purchase orders with a rubber stamp, or design and printyour own purchase order forms. Purchase orders should have at least three parts: a vendor copy, an internal file copy, and an accounting copy.

In addition to the standard purchase order, you might choose to use two other types: blanket purchase orders and annual contracts. If you routinely order fairly inexpensive items from a single vendor, you might want to place a blanket order for those items with the vendor. The blanket order covers specific items to be delivered over a specific period of time, such as six months or one year. This type of purchase order lets you take advantage of quantity discounts and saves you the time and trouble of reordering small items you need often. You will also receive a monthly invoice covering your purchases for a given month, instead of several small invoices covering each individual purchase.

Annual contracts cover the purchase of a specific product from a vendor over a period of 12 months. An annual contract will usually let you fix the price for buying a specific quantity of a given item over a year. You can also arrange to have goods delivered as needed, either monthly, weekly, or on another specific schedule.

Receiving Records

A packing list will accompany orders you receive. Make sure that the items shipped match the items indicated on the packing list. Inspect all of the items shipped carefully, paying special attention to items that appear damaged. Initial the packing list to verify receipt and file it in a folder until you receive the invoice for the shipment. In many cases, you won't have to send payment with your order; your suppliers will either include an invoice with the shipment or send the invoice to you separately soon after sending your order. When the invoice arrives, check it against the packing list and the purchase order. Write a check for the appropriate amount, note the check number on a copy of the invoice, and file the invoice and packing list.

If you receive any damaged items, or if a vendor sends you items you did not order, let the vendor know as soon as possible. The vendor will tell you the best way to return the items and to receive the ones you actually ordered.

Fill out an internal receiving report and distribute it to those who need to know when shipments come in, such as the person in charge of inventory control, the buyer, the employee requisitioning the items, and the person in charge of accounts payable in accounting.