Credit Sales Definition
Credit sales is selling goods or services to customers on credit, letting them purchase and make payment at a later date.
The buyer gets a product or service immediately in a credit sales transaction and will pay later. An invoice or sales receipt documents this and it includes credit sale terms, payment due date, and interest or fees.
Accounting software, such as an accounts receivable automation solution, makes tracking credit sales and outstanding payments easy.
How Credit Sales Work
- Sale Agreement: The seller and the buyer agree on the sale terms (the quantity and description of goods or services, the price, and the credit terms). Net terms show the time by which the buyer must clear the invoice. For example, "NET 30" means the payment is due in 30 days.
- Invoice Generation: The seller generates an invoice with the transaction details, including net terms, dues, and taxes (sales tax) or fees. Next, they send the invoice along with the goods or services.
- Goods/Services Delivery: The seller delivers the product or service.
- Credit Period: The buyer sets a period to pay according to the credit terms in the accounting cycle.
- Payment: The buyer must pay within the credit period. Various methods, such as checks, EFTs, and credit cards, can be used.
- Record Keeping: Both the buyer and seller maintain credit transaction records, vital for financial accounting. The seller tracks this as an accounts receivable.
- Dunning and Collections (if necessary): If the buyer doesn't pay within the payment term, the seller will follow up with reminders.
- Accounting Entry: The seller records the credit sale, recognizes revenue, and records the accounts receivable.
Note: Payroll accounting involves recording and managing employee compensation.
What industries use credit sales?
- Software
- Automotive
- Electronics
- Wholesale and Distribution
- Services
- Construction
- Manufacturing
Different Types of Sales Transaction
- Cash Sales: In a cash sale, the customer makes a cash payment immediately.
- Online Sales: Online sales are transactions over the Internet.
- Subscription Sales: Subscription sales have recurring payments for access to a product or service.
Note: The receivable turnover ratio shows how quickly a company collects on its credit sales.
What are Net Credit Sales?
Net credit sales refer to a business's gross sales minus returns, allowances, or discounts. It shows the revenue from credit transactions after accounting for adjustments.
The accounting equation for net credit sales is:
Net Credit Sale = Gross Credit Sales − Returns − Allowances − Discounts
The financial ratio for net sales provides a more accurate credit revenue, excluding reversed or discounted transactions.
Note: An accrued expense is an incurred cost that hasn't been paid. An accrued expense and a credit sale influence financial statements by increasing liabilities and assets.
How to Record Credit Sales
Recording credit sales helps create accurate and comprehensive entries on accounting records.
The process begins with creating the invoice or sales receipt.
Once the goods or services are delivered, the seller records the total sales in their accounts, crediting the sales revenue account and recording this on the income statement.
Simultaneously, a journal entry is made in the accounts receivable account, debiting it to reflect what the customer owes.
A sales allowance in the selling price (due to minor defects or customer negotiations) directly adjusts the credit sales revenue.
As the customer makes payments over time, the accounts receivable balance is reduced with sales returns while the cash or bank account is credited.
Regular accounts receivable bank reconciliation and financial statements generation help assess the sales return and effectively manage cash flow.
Note: Inventory management oversees inventory ordering, storing, and using inventory.
Benefits of Credit Sales for Sellers
Increased Sales Volume
Credit sales help companies get a more extensive customer base, as buyers are inclined to make purchases when they don't have to pay immediately, which results in increased sales volume.
Competitive Advantage
Credit terms give a business a competitive edge, especially in industries where competitors don't provide similar financing options.
Cash Flow Management
While payment can be delayed, credit sales allow companies to manage cash flow efficiently by generating revenue.
Customer Loyalty
Establishing credit relationships builds customer loyalty. Buyers prefer to do business with companies that offer payment terms.
Upsell Opportunities
Credit sales present opportunities for sellers to upsell or cross-sell additional products or services.
Benefits of Credit Sales for Buyers
Flexibility
Buyers can get goods or services without an immediate cash outlay.
Convenience
Credit sales offer convenience, allowing customers to get products or services immediately and pay later.
Budget Management
Buyers can spread the purchase cost over time. This makes it easy to budget and manage expenses.
Emergency Purchases
Credit terms are helpful for unplanned or emergency purchases, letting buyers tend to immediate needs without financial strain.
Establishing Credit History
Making timely payments on credit purchases helps companies build a positive credit history.
Note: Credit card transactions drive credit sales by letting customers purchase goods or services on credit.
Drawbacks of Credit Sales
- Delayed Cash Flow and Accounts Receivables: Businesses can face liquidity challenges if a significant portion of their sales is on credit.
- Credit Control: There is a risk that customers will not pay on time or default. This risk increases with customers with poor credit histories or unstable finances.
- Administrative Costs: Managing credit sales requires additional administrative efforts, including credit checks, invoicing, and accounts receivable monitoring.
- Interest Costs: The seller incurs additional costs if the credit term includes interest on overdue payments. This factor affects profitability when there are many debtors.
- Credit Assessment Challenges: Assessing creditworthiness can be challenging. Inaccurate assessments lead to increased non-payment risk.
- Potential for Bad Debt: Bad debt arises when customers cannot pay. Businesses will write off such debts, resulting in direct losses.
- Opportunity Capital Cost: The funds in accounts receivable collections can be spent elsewhere to generate returns. Credit sales cause an opportunity capital cost for the business.
- Complexity in Accounting: Accounting for credit sales involves complex transactions, including cash posting, tracking accounts receivable, and managing bad debt provisions. This challenges businesses with less sophisticated accounting systems.
- Dependence on Economic Conditions: Economic downturns increase default risk as customers face financial difficulties, leading to bad debt.
- Customer Relationships: Strict credit policies or aggressive debt collection practices strain customer relationships. Balancing timely payments while maintaining positive customer relationships is essential.
Credit sales can boost sales volume, enhance customer loyalty, and contribute to business growth.
However, companies must consider potential drawbacks, including delayed cash flow, non-payment risk, and other complexities.
FAQs
1) What is another name for credit sales?
Another name for credit sales is "sales on account".
2) Is credit sales the same as revenue?
Credit sales contribute to revenue but are not the same; revenue includes all income from sales, services, or other business activities, whether cash or credit.
3) Is credit sales an asset?
Credit sales create accounts receivable, an asset representing money owed to the company by customers.
4) How do you calculate credit sales?
To calculate credit sales, subtract cash sales from total sales or directly track sales made on credit through invoices.
