Customer credit limit

It is also called a trade credit limit or account limit. In an ERP or accounting system it sits on the customer record, so the system can warn about or block orders that would take the balance over it.

A credit limit works alongside payment terms. Terms say how long each invoice may stay unpaid, and the limit says how much may be unpaid at once, counting invoices that are not yet due. Both usually come out of the same credit decision, which is part of credit control.

How to set a credit limit for a customer

Start from what the customer needs, then cap it by what you are prepared to risk. When you use more than one of the first three methods below, take the lowest figure.

• Expected purchases. Monthly purchases including VAT, times your payment terms in days plus a margin for late payment, divided by 30. On 30-day terms with a 15-day margin, that is one and a half months of purchases.
• Financial strength. A cap set by your credit policy, such as a share of the net assets or working capital shown in the customer's latest accounts.
• Outside limits. The limit a credit reference agency suggests in its report, or the cover a trade credit insurer agrees for that customer, since sales above the insured limit carry no cover.
• Security. A deposit, a parent company or personal guarantee, or a letter of credit can support a higher limit than the other methods allow.

In the UK, filed accounts may tell you less than you expect. Small companies can choose not to file a profit and loss account and micro-entities file only a balance sheet, according to GOV.UK. Private companies have nine months after their year end to file, so the latest accounts may describe a year that ended more than a year ago.

Credit limit example

Example. Harbor Supply, a new customer, expects to buy about £25,000 a month excluding VAT on 30-day terms, or £30,000 a month including VAT at 20%. With a 15-day margin for late payment, the purchases method gives £30,000 × (30 + 15) ÷ 30 = £45,000. Its latest accounts show net assets of £400,000, and your policy caps any limit at 10% of net assets, or £40,000. You set the lower figure of £40,000, and all figures here, including the 10% cap, are illustrative.

Available credit equals the limit minus open invoices and goods delivered but not yet invoiced. In May, Harbor Supply owes £31,000 on open invoices and has £4,500 of goods waiting to be invoiced, so £40,000 minus £35,500 leaves £4,500. A new order worth £7,200 including VAT would take the account £2,700 over its limit.

What to do when a customer goes over its credit limit

1. Check the balance. An unapplied payment or a missing credit note can make the balance look higher than it is.
2. Ask for overdue invoices to be paid. If part of the balance is past due, paying those invoices may free enough room for the new order.
3. Split or prepay the order. Ship part of it now, or take part of it as payment in advance.
4. Approve a temporary increase. The person named in your credit policy signs it off with an end date.
5. Put the account on stop. Hold new orders until the balance is back under the limit, and make sure sales and finance tell the customer the same thing.

When to review a credit limit

Review every limit at least once a year, ideally when the customer files new accounts. Review it sooner when one of these happens.

• The customer starts paying later than its terms, or its balance moves into the older columns of your aging report.
• It asks for more credit, or its orders outgrow the limit.
• Your credit insurer cuts its cover, or a credit report shows a lower score or a court judgment.
• The customer changes owners or loses a major client.

In the US, Regulation B under the Equal Credit Opportunity Act also covers trade credit. If you turn down a customer's application for credit or for a higher limit, tell the customer within a reasonable time, orally or in writing, and give written reasons if it asks for them in writing within 60 days, as 12 CFR 1002.9 sets out.

Sunbay gives you the payment record behind these decisions. It connects to your ERP or accounting system, shows each customer's open and overdue balances with aging and DSO, flags invoices it predicts will be paid late and keeps every reminder, reply and promise to pay next to the invoice. See Sunbay analytics and insights.

Frequently asked questions

What is a credit limit for a business customer?

It is the most the customer may owe you at one time on credit terms, counting invoices that are not yet due as well as overdue ones. You set it as the supplier, and it is separate from the payment terms, which say how long each invoice may stay unpaid.

How do you calculate a credit limit for a new customer?

Multiply expected monthly purchases, including VAT, by your payment terms in days plus a margin for late payment, and divide by 30. Then cap the result by what the customer's accounts, a credit report or your credit insurer support, and use the lowest figure.

What happens when a customer exceeds its credit limit?

New orders usually go on hold until the customer pays enough to bring the balance back under the limit. You can also take a prepayment for the new order or approve a temporary increase.

Should a credit limit include VAT?

Yes, if you charge VAT. The balance in your sales ledger includes VAT, so work the limit out from invoice totals including VAT, as in the example above.