Question

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The major advantage of extending credit sales is that it will increase sales revenue. This is because customers who can't produce cash today are still able to buy the good or service of their choice.

Extending credit sales is usually a good idea for businesses, but there are a few important factors to consider. First, the business needs sufficient cash flow to account for Cost of Goods Sold (inventory). Customers' payments may delayed, but suppliers still have to get paid on time. Thus, the business has to be keenly aware of its cash levels.

This is especially true for businesses that sell large durable goods at low volumes, like airplane engines. If a customer is unable to pay its debt, this bad debt may have a big affect on cash levels available for suppliers and investment in other activities.

The most important factor to consider when deciding whether to offer credit sales is the anticipated bad debt expense. This is the percentage of credit sales that are not ultimately paid. The business will be forced to eventually write this off against the account receivables balance (credit). This may lead to a lower credit rating. A smaller account receivable balance, which is considered liquid, is not good if you wish to borrow against that balance (secured borrowing).

Ultimately, a business has to decide whether 1) the increase in sales revenue will be greater than the bad debt expense arising from extending credit to customers; and 2) whether the increase in sales revenue is sufficient to account for reduced and/or delayed cash flows.

It therefore goes without saying that the credit worthiness of customers should be evaluated before deciding to lend. Background checks and credit scores should be reviewed. The goal of course to minimize any future bad debt expense.

Answer 1

The situation described in the post is correct.

In today's business environment, it is practically impossible for any company to make sales without extending credit to its customers. While, there may be cash sales, its percentage may be very low. Therefore, in order to grow and expand business, companies are often required to offer credit to their customers. Credit sales result in creation of accounts receivable which indicates the amount that the company is required to collect from its debtors/customers. Accounts receivable is treated as a current asset (in the balance sheet) as it is expected to be collected within the next 12 months.

Extending credit, however, is not free from risks as some customers may delay/default on their payments resulting in loss to the company and affecting its liquidity position. Such accounts receivables are reported as bad debts and written off from the company's book of accounts on a periodical basis. Companies selling goods on credit usually maintain a provision for bad debts (which may be based on a percentage of sales or accounts receivable or any other method such as aging) to indicate the amount of receivables deemed to be uncollectible. This balance is adjusted at the end of the year.

In order to reduce/overcome the risks associated with providing credit to customers, some companies offer early payment discounts (however, a cost benefit analysis should be performed before giving such discounts). Further, customers are extended credit based on their credit history and previous experiences with the company. Information on a customer's creditworthiness may also be obtained from other market sources (such as banks/credit rating agencies) before providing credit (to any customer). Customers may be ranked (highest to lowest) based on their credit evaluation and offered credit accordingly. Poorly rated customers should be denied any form of credit and only cash sales should be made to them. Further, the company can include clauses like penalty on late payments (payments which are made after the expiry of the credit period) in the sales contract. The company can also sell its receivables to a factor in exchange for cash. This may result in loss on account of commission/fees charged by the factor for providing its services.

Therefore, it can be concluded that credit evaluation can play an important role in the entire sales process. If done properly, it can not only reduce the default risk, but can also result in quick conversion of sales into cash (by selling goods to customers with high credit rating) which in turn would improve the cash/liquidity position of the company.