What it means
Offering credit means handing over goods or services and hoping to be paid weeks later. The credit application is the point at which a business gathers enough information to make that a considered decision rather than an act of optimism.
A good application collects the exact legal entity name and registration number, the trading and registered addresses, the names of directors or owners, expected monthly purchase volume, requested payment terms, bank details and two or three trade references. The legal entity detail matters enormously, because chasing a debt owed by a company you have named incorrectly is slow and sometimes impossible.
The application also does legal work. It is normally where the customer signs acceptance of your standard terms, including payment periods, interest on late payment, retention of title over goods until paid, and sometimes a personal guarantee from an owner of a small company.
Assessment combines the application with external data. Most sellers check a credit reference agency score, review filed accounts, take up the trade references, and look at how long the business has traded.
The output is a decision: refuse credit, offer a limited amount, or grant the requested limit, often with a review date attached. Setting the limit is where judgement enters.
A limit should reflect what the customer realistically needs to trade with you, adjusted for the payment terms and for how much loss your business could absorb, rather than simply matching whatever number the customer asked for.
In practice
Real-world examples.
Example
A builders' merchant requires every new trade account to complete a credit application including a personal guarantee for limits above $25,000. When a two-year-old contractor applies for a $60,000 limit, it is granted only with the guarantee signed.
Example
A packaging supplier discovers during application checks that a prospective customer's legal entity was incorporated only four months ago, although the brand has traded for years under a previous company. It offers pro forma payment for six months rather than open credit.
Example
A staffing agency updates its credit application form to include retention of title and interest on overdue accounts. Two years later that clause is what lets it recover unpaid fees during a client's insolvency process.
Formula
Calculation
A common working rule is: Suggested credit limit = Average monthly purchases x (Payment terms in days / 30) x Safety factor.
Take a prospective customer who expects to buy $40,000 a month and has asked for 45-day payment terms. The exposure at any moment covers roughly one and a half months of purchases, so $40,000 x (45 / 30) = $40,000 x 1.5 = $60,000.
Applying a safety factor of 1.2 to allow for seasonal peaks and slightly late payment gives $60,000 x 1.2 = $72,000, which would sensibly be rounded to a $70,000 limit. If the credit reference agency suggests a maximum exposure of $50,000 for this customer, the lower figure wins and the limit is set at $50,000, with a note to review after six months of clean payment history.Case study
Seen in the real world.
This example is fictional and illustrative. Calder Print Supplies, an invented distributor of printing consumables, historically opened accounts on the strength of a phone call and a purchase order, with limits set by whoever answered the phone.
After writing off $118,000 across three failed customers in one year, the illustrative management team introduced a formal credit application. It required the registered company number, two trade references, the last filed accounts for limits above $30,000, and signed acceptance of terms including retention of title.
Sales resisted at first, arguing the form would cost them deals. In the following year Calder opened 12% fewer new accounts but wrote off only $19,000, and the retention of title clause allowed it to recover roughly $22,000 of stock from one failed customer. The board judged the trade-off comfortably worthwhile.
Watch out
Common mistakes.
- Accepting a trading name instead of the registered legal entity. If the invoice and the application name the wrong entity, enforcement becomes difficult and sometimes hopeless.
- Treating the application as a one-off. Customers change ownership, take on debt and lose their own big clients, so limits need periodic review rather than being set once and forgotten.
- Setting the limit at whatever the customer requests. The limit should reflect realistic trading volume and your own tolerance for loss, not the customer's ambition.
Questions
People also ask.
How long should approving a credit application take?
Most businesses aim for one to two working days, because slow decisions genuinely lose sales and encourage salespeople to bypass the process.
Are trade references worth taking up?
Yes, though with care, since customers naturally nominate their best-paid suppliers. Ask specific questions about the highest balance and the average days taken to pay rather than a general opinion.
Should we ask for a personal guarantee?
It is common for small or newly formed companies and for larger limits, but it slows the process and can lose deals, so many sellers apply it only above a threshold.
From the founder's library
Take it further with the book.
Build your financial confidence beyond this definition. Shihan's full-length guide, Accounting Fundamentals, takes the same plain-English approach and turns it into a complete, practical playbook for non-finance managers, business owners and students - with chapter-end quiz answers and presentation slides included.
25% off with code MMHQ25, applied at checkout. Priced in USD - checkout may show the equivalent in your local currency.
View the book and save 25%