Question

Please explain in 100 words or more:

What is a sensible credit period? Should the credit period for your company's sales vary depending on the industry in which you are operating?

Answer 1

What is a Credit Period?

Definition: A credit period is the time frame between when a customer purchases a product and when the customer’s payment is due. In other words, this is the amount of time a customer has to pay for the product.

What Does Credit Period Mean?

Most companies have credit policies set up with vendors or customers, so purchases can be made on account. These credit purchases help speed up commerce and increase sales because it allows customers to purchase items before they actually have the funds to buy the products.

Before a credit sale can be made, credit terms must be established. 2/10 N/30 is the standard term for transactions across almost all industries. This means that if the customer pays for the product within ten days he gets a 2 percent cash discount. If the discount isn’t taken, the customer must pay the full invoice price within 30 days from the purchase. This 30-day time frame is considered the credit period. It’s the amount of time the seller is giving the buyer credit for the transaction.

The credit period is the number of days that a customer is allowed to wait before paying an invoice. The concept is important because it indicates the amount of working capital that a business is willing to invest in its accounts receivable in order to generate sales. Thus, a longer credit period equates to a larger investment in receivables. The measure can also be compared to the credit period of competitors, to see if other companies are offering different terms to their customers. For example:

• If the company grants terms of 2/10 net 30, this means the credit period is 10 days if the customer chooses to take a 2% early payment discount, or the credit period is 30 days if the customer chooses to pay the full amount of the invoice.

• If the company grants terms of 1/5 net 45, this means the credit period is 5 days if the customer chooses to take a 1% early payment discount, or the credit period is 45 days if the customer chooses to pay the full amount of the invoice.

The credit period does not refer to the amount of time that the customer takes to pay an invoice, but rather to the period granted by the seller in which to pay the invoice. Thus, if the seller allows 30 days in which to pay and the customer pays in 40 days, the credit period was only 30 days. If the seller is requiring multiple payments over time, the credit period is the interval from when credit is first extended until the last payment is supposed to be made by the customer. Thus, if the seller allows for three monthly partial payments, with the last payment due in 90 days, the credit period is 90 days.

An entirely different concept is the collection period, which is the actual amount of time it takes for the seller to obtain payment from the buyer. Depending on the credit quality of the buyer, the collection period can be substantially longer than the credit period.

When a company requires cash-on-delivery terms, the credit period is zero days, and the collection period is also zero days.

Let’s take a look at an example.

Example

Tim’s Machine Shop purchases steel and other raw materials from vendors on a regular basis. As part of his agreement with these vendors, he can pay cash for these purchases within 5 days and receive a 15 percent discount. Otherwise, all payments are due within 25 days.

The first five-day period is considered the early pay discount period. Tim can pay for the entire order in the five-day window if he wants to, but he isn’t required to. Tim is however required to pay for the full order within 25 days. This means the vendor is giving Tim a credit period of 25 days to pay for the purchase.

Businesses like Tim’s can use the extra 25 days to structure their cash flows appropriately. Since the full payments aren’t due up front, Tim can order the materials he needs, sell them to a customer, and pay the vendor with the income received from the customer.