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 business sector, the sales of many companies are sold with payment terms (credit sales), generally ranging from 30 to 90 days.
Obviously, the use of cash sales versus credit sales and the duration of the latter depend on the nature of the business of a business. Along with consumer goods and services, the credit card has turned most retailers’ sales into cash sales. However, outside of the consumer sector, almost all sales by business involve, at a minimum, payment terms, and therefore sales on credit. In modern times, credit sales are the norm and dominate virtually all business-to-business transactions.
If a company has a mix 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 publicly traded company’s annual report or of 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 several days or weeks after a product is delivered.
- Short-term credit agreements appear on a company’s balance sheet as accounts receivable and are different from payments made immediately in cash.
- To determine the percentage of credit sales, divide accounts receivable by sales.
This question involves an important analytical point that investors should take into account when measuring the quality of a company’s operations and balance sheet. In the latter case, the accounts receivable line of a company’s 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 may give a better indication of how successful the business is in converting credit sales to cash. Well-run businesses typically aim for an average payback period about a third less than maximum credit terms. For example, if the terms say payment within 30 days, the business will aim to collect within 20 days.
The average collection time is calculated by dividing the total annual credit sales by half of the sum of the opening receivables balance and the closing receivables balance. The average collection time, along with the debt turnover rate, provides useful insight into assessing the cash flow and overall liquidity of the business.