A credit limit is the maximum amount of credit offered to a customer. 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.
The credit limit is used to limit the amount of loss that a business will sustain if a customer does not pay. The amount of a credit limit is established by the credit department. The amount of the credit limit is based on a number of factors, such as:
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.