What is a Credit Limit?

A credit limit is the maximum amount of credit offered to a customer. It is used to limit the amount of loss that a business will sustain if a customer does not pay. It is especially useful when applied to new customers or customers that have a history of late payments.

The amount of a credit limit is established by the credit department, which monitors the financial condition of all customers, as well as their promptness in making timely payments.

How to Set a Credit Limit

The amount of the credit limit granted to a customer is based on a number of factors, such as the following:

A customer’s credit score, as calculated by a credit rating agency.
The customer’s payment history with the company.
The customer’s financial results and financial position, as described in its financial statements.
The presence or absence of any personal guarantees or other collateral.

The credit department may find itself under pressure from senior management or the sales manager when a customer wants to place an unusually large order, where they want the credit limit to be increased in order to record a large sale. While doing so can enhance reported revenues, it also increases the risk of incurring a large bad debt loss.

Why Does a Credit Limit Matter?

A credit limit is of critical importance to both a business and an individual, because it caps the amount of credit that can be used to defer payments for items in the short term. This means that you need to be aware of the remaining amount of credit with your suppliers, so that you can control your spending to remain within these limits. It is also useful to maintain some unused capacity in your supplier credit, since you will be awarded a better score if you have not tapped them all out. This is because using all of your credit is a sign that you are financially stretched.

Example of a Credit Limit

For example, a supplier grants a credit limit of $5,000 to a customer. The customer makes $3,000 of purchases on credit, which reduces the available credit limit to $2,000. At this point, the customer can make additional purchases on credit of $2,000, but must pay down some of the outstanding balance in order to make a larger purchase on credit.