Latest / Cash Flow Conversations with Fexingo: Working Capital, Receivables, and Small Business Finance / How Credit Limits on Customers Free Up Cash
Transcript
- Lucas: Luna, I want to start with a number that stopped me this week. The average small business in the US carries about 42 days of sales in receivables. That's six weeks of cash they've already earned but can't touch. Luna: Six weeks is brutal. Especially if you're a 10-person shop with payroll due every two weeks. Lucas: Exactly. And a lot of owners think the only levers are 'call faster' or 'offer a discount'. But there's a structural move that most businesses underuse: setting actual credit limits on your customers. Luna: You mean like a credit card limit, but for trade credit? Lucas: Precisely. You decide the maximum amount a customer can owe you at any given time, based on their payment history and your risk appetite. If they hit the limit, you stop shipping until they pay down the balance. Luna: That sounds confrontational. Won't customers just leave? Lucas: Some might. But let me give you a real case. I spoke with a wholesale distributor in Ohio — $2 million in annual revenue, sells industrial supplies to about 80 contractors. Before they set limits, their average receivables were 58 days. Cash was always tight. Luna: Fifty-eight days is almost two months. How did they survive? Lucas: They were using a credit line to bridge the gap. Paying interest on money they'd already earned. So the owner, a woman named Diane, decided to implement a tiered credit limit system. She used three tiers based on how long a customer had been with her and their payment record. Luna: What were the tiers? Lucas: Tier one: new customers with less than six months of history. Max credit of $2,000. Tier two: six to eighteen months, clean payment record — limit of $10,000. Tier three: over eighteen months, never late — limit of $25,000. She grandfathered her oldest clients into tier three automatically. Luna: And how did the customers react? Lucas: She lost two customers in the first month. Both were small operators who habitually paid at 90 days. But within six months, her average receivables dropped to 38 days. That's a 20-day improvement. Her credit line balance went from $180,000 to $90,000. Saved about $8,000 in interest that year. Luna: The math works. But how do you decide what credit limit to set for a specific customer? Is there a formula? Lucas: There's a rough benchmark that commercial credit managers use. You take the customer's monthly purchase volume, multiply by the number of months you're willing to wait for payment. So if a customer spends $5,000 a month and you're comfortable with 30 days net, your limit is around $5,000. If they're a slower payer, you might use two months: $10,000. Luna: That's simple. But what about customers who fluctuate a lot — one month they buy $2,000, the next month $20,000? Lucas: Then you use a rolling three-month average of purchases. That's more stable. And you revisit the limit every quarter. Diane did exactly that — she'd look at the past 90 days of invoices and adjust. Luna: One thing that worries me: if you cut off a big customer mid-month because they hit their limit, that could damage the relationship. How do you handle that gracefully? Lucas: You communicate the policy upfront. Diane sent a letter to every customer explaining the new credit limits — framed it as a way to keep prices low by reducing her own borrowing costs. She also gave a 15-day grace period before enforcement. And for key accounts, she offered an exception: if they exceeded the limit, they could still get an emergency shipment if they paid 50% upfront. Luna: That's a good compromise. What about credit insurance? Does that change the calculus? Lucas: Credit insurance can be a smart addition. You pay a premium — typically 0.5% to 1% of insured receivables — and the insurer covers you if a customer defaults. That lets you set higher limits with more confidence. But it's not a substitute for a limit policy. Insurance usually covers only 75% to 90% of the invoice value, and it doesn't speed up payment. Luna: So the limit forces the behavior; the insurance just protects the downside. Lucas: Exactly. And there's a data source many small businesses don't use: business credit bureaus. Dun and Bradstreet, Experian, Equifax all offer credit reports on other businesses. You can get a PAYDEX score for a customer — it's like a FICO score for companies. Costs about $50 to $100 per report. Diane used that to set initial limits for new customers she'd never worked with. Luna: How did she use the score? Lucas: She set a floor: if a new customer had a PAYDEX score below 50, they started at tier one regardless of how much they wanted to buy. If the score was above 70, she'd start them at tier two. That way she wasn't guessing. Luna: And if a customer's score was low but they objected? Lucas: She'd offer them the option to prepay for the first three orders. Then she'd pull a fresh report and reconsider. Most agreed. And about half of those eventually moved to tier one after showing good behavior. Lucas: Now, I want to talk about enforcement. A credit limit is only useful if you actually enforce it. Diane had a simple rule: when an order would push the customer over their limit, the system automatically flagged it. She'd call the customer and say, 'Your current balance is $9,500 and your limit is $10,000. This order is $800. Can you send a payment for $500 today so we can ship the full order?' Luna: That's smart. You're not saying no — you're offering a path to yes. Lucas: Right. Most customers would pay the $500 on the spot. Over time, they learned to pay more frequently. One customer actually set up automatic weekly payments to stay under the limit without having to think about it. Luna: I wonder about the psychology. If you never set a limit, customers treat your payment terms as a suggestion. But once there's a hard number, it becomes real. Lucas: That's exactly what Diane found. Before, her customers didn't think about her payment terms at all. After, they'd ask, 'What's my limit?' It became a conversation. She said it changed the dynamic from 'please pay me' to 'here's how we work together.' Luna: One potential downside: if you have a very large customer who accounts for 30% of your revenue, setting a limit could be risky. They might walk. Lucas: That's a real concern. For large strategic accounts, you might set a much higher limit or even no limit — but then you offset the risk with credit insurance or a personal guarantee from the owner. Diane had one customer that did $400,000 a year with her. She set their limit at $50,000 and had the owner sign a personal guarantee. That way she had recourse if things went wrong. Luna: A personal guarantee from the business owner, not just the business. That's a strong tool. Lucas: It is. And it's surprisingly negotiable. Many owners will sign if you explain that it allows you to give them a higher limit and better service. You have to frame it as a partnership. Luna: I want to circle back to the data side. How often should you review credit limits? Lucas: Quarterly is standard. But Diane also set triggers: if a customer's payment pattern changed — say they were always on time and then started paying 10 days late two months in a row — she'd review immediately. She'd also pull a fresh credit report once a year for any customer over $10,000. Luna: That sounds manageable. What software do you need to do this well? Lucas: Surprisingly little. Diane used QuickBooks and a simple Excel spreadsheet. She had a column for customer name, credit limit, current balance, and last payment date. When a new order came in, she'd check the spreadsheet. The key is discipline, not technology. Luna: You know, this episode is exactly the kind of practical advice we try to deliver here. No fluff, just a system you can implement. Lucas: That's the goal. And it's why we keep these conversations ad-free. We want you to get actionable ideas without interruption. If these episodes have helped you tighten up your cash flow or make a smarter decision, and you'd like to support that, we have a small tip jar: buy me a coffee dot com slash fexingo. No pressure, just an option for those who find value here. Luna: Absolutely. It's a way to keep this resource free for everyone who needs it. Now, back to limits — one last question. What's the single most common mistake businesses make when they start setting credit limits? Lucas: Setting the limit too high. They're afraid of losing sales. But a limit that's too high doesn't change behavior. If you set a $50,000 limit for a customer who typically owes $5,000, it's meaningless. The limit has to be tight enough that the customer actually bumps into it occasionally. Diane's sweet spot was a limit about 1.5 times the customer's average monthly purchase. Luna: So if they usually buy $10,000 a month, set the limit at $15,000. That way they'll hit it if they fall two months behind. Lucas: Exactly. And that's the whole point — to catch the problem before it grows into a six-month-old receivable. Credit limits are preventive medicine, not a cure. Luna: Preventive medicine. I like that. So next week, any business owner can start by pulling their top 10 customers by revenue, checking their current balances, and deciding a reasonable limit for each. Lucas: Start with the top 10. Communicate the change. Enforce it consistently. Within a quarter, you'll see your days sales outstanding drop. And that cash — it's already yours. You just need to bring it home.