What is a credit limit?
The maximum balance a customer is allowed to carry on account. The cap is a policy on the customer record, not a journal account of its own.
Definition
A credit limit is the ceiling on how much a customer may owe you at one time. In the books it is a policy cap on accounts receivable, not a journal account of its own.
The cap does not post a debit or a credit when you set it. It only decides whether the next sale on account is allowed.
Where it shows up
Balance Sheet: Related to how large the open receivable is allowed to get.
P&L: Related to nothing extra unless a later sale is blocked or written off.
Cash flow: Related to nothing sitting as cash until invoices collect.
See also: Credit Application · Customer Credit Check · Accounts Receivable
When you look at the Balance Sheet, you will not find a line named for this cap. You will find the customer's open invoices inside accounts receivable, and the cap is the most that pile is allowed to reach.
The Income Statement does not change when you set or change the cap. Revenue is recorded only when you make a sale, and a blocked sale is a sale that never happened.
Cash does not move when you set the cap. Operating cash later depends on whether the invoices under that cap actually collect.
A high cap on a slow-paying customer can leave a large receivable sitting in current assets. A tight cap keeps that receivable smaller.
How it works
Someone in the shop assigns a dollar ceiling after they review the customer. That review is a separate step from the cap itself.
The cap is stored on the customer record. New orders on account are compared to open invoices plus the new order.
If the new order would push the open balance over the ceiling, the order is held, refused, or taken as cash only. If the new order fits under the ceiling, the sale goes through and the receivable grows.
Payments lower the open balance and free room under the same ceiling. A customer who pays down $500 can usually charge another $500 without a new approval.
You can raise or lower the ceiling later. A raise is still a policy change, not a journal, and a lower ceiling does not write the existing receivable down.
The cap is not payment terms. Payment terms say when each invoice is due, while the cap says how large the unpaid pile may get even if every invoice is still inside its due date.
The cap is also not a guarantee you will collect. A customer can still sit at the ceiling and pay slowly, which stretches days sales outstanding.
Example
A florist sells weekly bread arrangements to a neighborhood cafe. The florist sets a $2,000 ceiling on that cafe's open invoices.
The cafe already has $1,800 of unpaid bread invoices. A new $400 order would take the open balance to $2,200, so the florist holds the order.
The cafe pays $400 against the oldest invoice. The open balance falls to $1,400, and the $400 order now fits under the $2,000 ceiling.
No journal is posted for the cap itself. The books only change when the allowed invoice is issued, or when a payment comes in.
If the florist later cuts the ceiling to $1,000, the existing $1,400 receivable stays on the Balance Sheet. New orders stay blocked until the cafe pays the extra $400 down.
Common mix-ups
A credit limit is not a credit application. The application is the form the customer fills out, and the limit is the dollar ceiling you assign after you decide to say yes.
A credit limit is not a customer credit check. The check is the review of whether they can pay, and the limit is the number you put on the account after that review.
A credit limit is not payment terms. A due-date rule sets when each invoice is due, while the limit sets the maximum unpaid total even when every invoice is still current.
A credit limit is not the receivable itself. Accounts receivable is the actual unpaid balance, and the limit is only the ceiling that balance is not supposed to cross.
Related terms
- Credit Application: The form a customer completes to be approved for terms.
- Customer Credit Check: The review of a customer's ability to pay before granting terms.
- Accounts Receivable: Money customers owe the business for goods or services already delivered.
- Collections: The process of following up on unpaid customer invoices.
- Payment Terms: The agreed deadline and conditions for paying an invoice.
- Accounts Receivable Aging: A report bucketing open invoices by how long they have been outstanding.
- Bad Debt Expense: The expense recorded when receivables are judged uncollectible.
- Sales Order: The internal record of a customer's confirmed order.