Credit Management Article -Credit Guru

Credit Limits | Line of Credit

Although credit associates make a difference between ‘line of credit and ‘credit limit’ and there are some legal ramifications for both but for the purpose of the following article we will leave the difference alone and treat them the same.

Like most elements in credit management, setting ‘credit limits’ is an art and not a science of granting credit. There are seasoned credit professionals that have used and relied merely upon their gut feeling to grant credit limits. However, it is always better to take a ‘calculated’ risk than base your decision purely on gut feeling!

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:

It frees up valuable time for other credit management tasks It speeds up the sales process It reduces risk and improves collection activity and efforts. 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 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.

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. 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.

Examples:

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.

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.

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.

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:

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; 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 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.

Here's what to do if you didn't get the credit limit you wanted

Applying for a new credit card might seem like the perfect solution when you want to manage your spending in a way that works for you.

Be it an intro 0% APR that you're after, or just more generous rewards on purchases, credit cards let you buy now and pay later, helping you take control of big projects like home renovations and even everyday spending.

As convenient as credit cards are, however, there's no guarantee that you'll be approved for the credit limit you want. It can be a let down to submit an application only to receive a credit limit that's lower than your expectations, and worse — it can put your goals up in the air.

On average, consumers who open a store card may only receive a limit between $2,000 to $2,500, and it can be below $1,000 in some cases, according to Equifax’s Credit Trends report. The average credit limit for general-use cards was higher, averaging between $5,000 to $6,000, but that can still be low for your needs.

Creditors look at a host of factors when deciding your limit, including their assessment of your credit risk, your income level, your credit score and issues they see on your credit report such as high revolving credit card balances, recent inquiries or large loan amounts.

But they take into account a few completely independent factors, too, like how well the economy is doing at the time you applied. There's no way to predict exactly how much you can expect to be approved for.

It can be disappointing to get a low credit limit, but you're not entirely without options. After a few months, consider asking for a credit limit increase on your new card, or you can request a higher limit on a card you've had for a while.

Here's a breakdown on how credit limit increases work and how you can request one.

How Do You Get a Credit Card With a High Credit Limit?

What is a credit card limit?

Your credit card limit is the maximum amount of money you can charge to your credit card. Once you learn how credit limits are determined, you can increase your chances of qualifying for a high credit card limit.

How is a credit card limit determined?

Credit card limits reflect how much money an issuer thinks cardholders can borrow and manage responsibly. Your credit score is an important factor in determining your credit card limit, but a high score alone does not necessarily guarantee a high credit limit. To determine credit limits, issuers typically look at your credit history, your income, and how much you pay for your rent or mortgage.

What’s the best way to get a high credit card limit?

Each issuer has its own criteria for determining credit card limits and may weigh individual components of your credit profile uniquely. The best way to get a high credit limit is to make sure all the components that affect your credit score are in good standing.

Factors that help determine your credit card limit

Credit report

Your credit report is very important when it comes to determining your credit limit, and it includes:

Payment history: Your payment history — which can account for a significant percentage in credit scoring models — is a measure of your creditworthiness. The thinking typically is, if a cardholder has paid their bills on time in the past, odds are they’ll do so in the future. Ensuring you always make your credit card payments on time is one of the best long-term paths to a higher credit limit.

Credit utilization: Credit utilization refers to the amount of a person’s credit in use compared to their total credit available. A lower credit utilization — less relative credit in use — will generally be better for card approval and credit limit determination.

Credit card issuers may look at both overall credit utilization and utilization on individual lines of credit when determining the size of a credit card limit on a new account. If you plan on applying for a new card in a few months, paying down some existing balances could help raise your credit limit.

Length of credit history: Having a longer credit history gives issuers a larger pool of data to predict how you’re going to use credit moving forward, and a long history of responsible credit use will generally help improve your odds of a higher credit limit.

Recent inquiries: A person who’s applied for a handful of credit cards — or other lines of credit — in a short period of time may be viewed as a risk by issuers, and could receive a lower credit card limit. When you apply for a credit card, your credit receives a “hard inquiry,” and too many of those in a short period of time will likely impact your credit score.

Personal income and monthly expenses

Your income and housing costs may help determine your credit limit. If an applicant has a high income with a relatively low rent or mortgage, odds are they have more discretionary income and thus may qualify for a higher spending limit, depending on other factors.

Does a high-limit credit card affect your credit score?

Although a high-limit credit card doesn’t affect your credit score by itself, having a high total limit makes it easier to improve your credit utilization ratio. For example, if you have two credit cards with a total credit limit of $5,000, and your balance is $2,500, your credit utilization ratio is 50%. But if you add high-limit cards that increase your total available credit to $25,000, your credit utilization for the same balance would be 10%. This means that having high-limit cards lets you run a larger balance without your credit utilization ratio hurting your credit score.

What happens if you go over your credit limit?

Depending on the terms of your cardmember agreement, your credit card issuer may charge you a fee for going over your limit, or the transaction may be declined.

Can you raise the credit limit on your credit card?

If you don’t receive your ideal credit limit right after applying for a card, don’t fret. Many issuers have been known to increase credit limits on their own over time. And if you’ve used a card for a while without any missed payments or other negative activity, you can request an increase yourself.

Can your credit limit be reduced after it’s determined?

You might think that a high credit limit won’t go down once you have it. But having a high credit limit doesn’t mean you can ignore the factors that determine your credit limit. Card issuers periodically review your credit score, and if you’re consistently using a large percentage of your high credit limit, your score may be affected and your limit may be reduced.

Is it better to ask for a credit limit increase or apply for a new credit card?

Whether applying for a new credit card or requesting a line increase, these actions may impact your credit score, but increasing the limit on an existing card will usually have a lesser effect. However, if your credit score is already high, it might be worth applying for a new card to get rewards that are only offered to new cardholders. For example, Discover Cards offer Cashback Match to new cardmembers, which means that Discover will automatically match all the cash back you earn in your first year.1

Your individual credit history will determine whether it’s best to request a limit increase on an existing credit card or apply for a new card.