What is a ‘credit limit’?

A credit limit refers to the maximum amount of credit that a customer is allowed to utilize from a lender or creditor. It is an essential financial management tool for businesses to mitigate risk when extending credit to customers. By establishing a credit limit, businesses can ensure they do not expose themselves to excessive risk if the customer defaults on payment. This limit is typically determined based on the customer's creditworthiness, payment history, and financial stability.

Understanding the concept of a credit limit is crucial in accounts receivable management, as it helps in keeping track of how much credit has been extended and ensures that payments are made within acceptable timeframes. It acts as a safeguard that aids businesses in managing their cash flow and reduces the likelihood of bad debts resulting from unpaid invoices.