Credit Limit: Definition and Example

Tally Solutions |Updated on: March 11, 2022

What is Credit Limit?

A credit limit is the maximum amount of credit offered to a customer. A credit limit is based on several factors that influence a borrower's ability to repay. Generally, the applicant's credit score, income and job stability are the main factors considered in determining an appropriate credit limit.

After a financial institution or a seller has approved an applicant's or a buyer’s request for a credit card or another type of revolving credit, the lender will decide on the maximum amount of credit they’re willing to extend to that person; this maximum amount is known as the credit limit.

Understanding Debtor Management

Debtors make an important position in the structure of current assets of your firm. Your debtors would earn credibility based on their credit score which is evaluated based on the payments to your firm they have taken credit from. Trade debtors represent amounts owed to the firm as a result of credit sale of goods or services in the ordinary course of business. The key function of credit management is to optimise the sales at the minimum possible cost of credit.

Each firm has its own credit management policy based on which it decides to provide a timeframe for debtors to pay their dues. The formulation of debt management policy seeks to achieve a balance between extending sales and the likelihood of these sales being profitable and collectable. It is quite possible that the receivable turnover is low, and the payment performance is high, indicating that the customers cleared their outstanding, but took a long time doing it. That’s when an accounting software would aid in assessing both the receivable turnover in days and the customer's actual payment performance.

Example

A supplier grants a credit limit of INR 5,00,000 to a customer. The customer makes INR 3,00,000 of purchases on credit, which reduces the available credit limit to INR 2,00,000. At this point, the customer can make additional purchases on credit of INR 2,00,000, but must pay down some of the outstanding balance in order to make a larger purchase on credit.

When you reach your credit limit, you simply make payments to pay down the debt.  As you pay down the balance, that money is again available to you to borrow.

Be careful about borrowing up to your credit limit.  Ensure that you do not make bulk purchases on credit, that you have trouble paying them off and create a lot of financial stress in your life.  Be disciplined in their use and faithful in making your payments.