Many businesses sell items to customers on credit or advance a product with the expectation that payment will be made soon after. It must be established from the outset that, depending on the sector of activity, the sales of many companies are sold with payment terms (sales on credit), generally varying from 30 to 90 days.
Obviously, the use of cash sale versus credit sale and the duration of the latter depend on the nature of the company’s activity. Along with consumer goods and services, the credit card has turned most retail sales into cash sales. However, outside the realm of consumption, almost all sales by businesses involve, at a minimum, terms of payment and, therefore, sales on credit. In modern times, sales on credit are the norm and dominate virtually all business-to-business transactions.
If a company has a combination of cash and credit sales, a breakdown of this nature would only be found in the notes to the financial statements or in the Management’s Discussion and Analysis (MD&A) section of a listed company’s annual report. scholarship or Form 10-K. However, we have rarely seen this type of disclosure.
Key points to remember
- Credit sales are payments that are not made until days or weeks after delivery of a product.
- Short-term credit agreements appear on a company’s balance sheet as accounts receivable and differ from payments made immediately in cash.
- To determine the percentage of sales on credit, divide accounts receivable by sales.
This question involves an important analytical point that investors should consider when measuring the quality of a company’s operations and balance sheet. In the latter case, a company’s accounts receivable line of current assets records its sales on credit. It is important to a company’s liquidity and cash flow that accounts receivable are collected (or turned into cash) in a timely manner.
For businesses with a high percentage of credit sales, the average payback period can give a better indication of how well the business is converting its credit sales into cash. Well-run businesses typically aim for an average collection period of around one-third less than maximum credit terms. For example, if the terms stipulate payment within 30 days, the company will endeavor to collect within 20 days.
The average collection period is calculated by dividing the total annual credit sales by half the sum of the balance of the beginning receivables and the balance of the ending receivables. The average time to collect, as well as the turnover rate of receivables, offer useful information to assess the cash flow and overall liquidity of the company.