Determining a company's credit limit is an essential process that helps assess a client's ability to make payments and manage liabilities. It is relevant to do this both when starting cooperation with new clients and when renewing post-payment terms for existing partners. Although some credit bureau agencies in Latvia offer credit risk calculation services, most companies develop their own methodologies based on historical experience and specific business needs.

Capitalia, which has been financing companies in the Baltic States for more than 15 years, has created its own credit risk model that takes into account more than 50 different company and market parameters. However, any credit risk calculation is based on some key indicators that other companies can also use to improve their receivables management system. We would like to share them with you in this article.

Main criteria for determining a credit limit
The three most important parameters for calculating credit risk are:
1. The amount of equity. Equity serves as a buffer for unforeseen situations. Companies with more equity have a better chance of covering their liabilities and overcoming financial difficulties.
2. Company turnover. Larger companies are generally better at managing cash flow and are more reliable payers. Turnover indicates the scale of the company's operations.
3. Business profitability . Profit is an indicator of the efficiency of a company's operations. Ideally, it should be at or above industry averages.

Additional factors or "multipliers"
In addition to the main criteria, the following factors also affect the calculation of the credit limit:
1. Duration of operation
Long-standing companies usually demonstrate better payment discipline and the ability to adapt to different market conditions.
2. Industry
Statistics show that some industries have a higher risk of default (such as construction, catering and transportation), while other industries (such as food retail or healthcare) are considered the most stable.

Disqualifying criteria
The company's payment discipline and the reputation of the business or owner are two of the most frequently used factors that can lead to a refusal to grant any credit limit. Debts to the State Revenue Service or other negative credit history records indicate existing financial problems. In turn, a dubious reputation of the company or its management (for example, on the sudzibas.lv portal) can disqualify a business as a potential cooperation partner.

Credit limit calculation example
Let's look at an example of a company in the manufacturing sector with the following indicators:
* Turnover: EUR 4.3 million
* Profit: EUR 0.5 million
* Equity: EUR 0.8 million

For the credit limit formula, we will use one month's turnover, three months' profit, and the total amount of equity, giving each indicator equal weight:
1. Turnover credit limit: 4.3 / 12 = 0.358 million (EUR 358 thousand)
2. Profit credit limit: 0.5 / 4 = 0.125 million (EUR 125 thousand)
3. Equity credit limit: EUR 0.8 million
Average result: (0.358 + 0.125 + 0.8) / 3 = 0.427 million or EUR 427 thousand. It should be noted that this would be the total (not each cooperation partner's) amount of credit obligations that the company could fairly safely assume.
An additional multiplier can be used, for example, as follows. If the company has been operating for more than 10 years, assign a multiplier of 1.5 to the result, while if less than 3 - then a multiplier of 0.5. According to a similar principle, multipliers can be assigned to safe and riskier sectors of the company's operations.

Important considerations
When calculating credit limits, it is important to take into account a couple of very important considerations. First, for companies that are not required to have their financial statements audited, the quality of accounting data can often be quite unreliable. Most often, this can manifest itself in poor inventory and receivables records. The second very important factor is the freshness of the available data. Official annual reports are usually available with a significant delay and are rare, so it is impractical to judge the company's financial position in December 2024 based on 2023 data. In such situations, it is necessary to familiarize yourself with operational financial reports.

By properly evaluating all these factors and using an appropriate model, it is possible to accurately determine a company's credit limit and mitigate the risks associated with cooperation.