In accounting, credit sales refer to sales that involve extending credit to the customer. The customer takes the product now and agrees to pay for it later. Credit sales are a type of trade credit. They create receivables, or moneys owed to the company from customers.
Credit sales terms often require payment within one month of the invoice date, but may also be for longer periods. Many companies offer discounts for early payment of receivables. For many companies, all of their sales are credit sales. Most of the commercial transactions between businesses involve trade credit. Trade credit facilitates business to business transactions and is a vital component of any commercial industry.
Sales made on credit are essentially like offering an interest-free loan to the customer. In this sense, it represents a cost to the seller and motivates the seller to collect receivables as soon as possible.
Credit Sales and Average Collection Period
The average length of time it takes a company to collect payment for credit sales from customers is called the average collection period. A shorter collection period shows a company that is able to collect its receivables quicker and thereby reduce the implied cost or opportunity cost of the interest-free loan to the customer.
On the other hand, a company that has a comparatively long average collection period is clearly having trouble collecting payments from customers and this could be a sign of inefficient operations.
Credit Sales Example
For example, if a widget company sells its widgets to a customer on credit and that customer agrees to pay in a month, then the widget company is essentially extending an interest-free loan to the customer equal to the amount of the cost of the purchase.
As long as the customer puts off paying for the purchase, the widget company is paying interest on loans that are tied up in the accounts receivable account due to the sale that was made on credit. In this sense, the widget company is paying interest on the customer’s loan.
The widget maker would be better off trying to get the customer to pay as soon as possible. To do so, the widget company may offer a discount to the purchase price for early payment. For example, the widget company may offer its customers a deal like 2% ten, net thirty. This deal states that the customer gets a 2% discount if they pay within ten days, otherwise they pay the full amount in thirty days. The 2% discount, when calculated out as yearly savings, turns out to be quite a substantial discount and a powerful incentive for the customer to pay early.