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Credit Sales

Guide to Understanding Credit Sales

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Credit Sales

How to Calculate Credit Sales

Credit sales are recorded when a company has delivered a product or service to a customer (and thus has “earned” the revenue per accrual accounting standards).

However, while the revenue may be recognized on the current period income statement, the cash component of the payment obligation on the customer’s end has not yet been fulfilled.

Until the customer pays the company the amount owed in cash, the value of the unmet payment sits on the balance sheet as accounts receivable (A/R).

Companies accept payment from customers on credit under the impression that the payment will soon be completed, which is the reason that accounts receivable is categorized in the current asset section (i.e. with high liquidity).

The average collection period measures the amount of time necessary for a company to obtain cash payments from customers.

While the benchmark for the average collection period will differ by industry, the most often cited figure for cash retrieval is around 30 to 90 days.

  • Shorter Average Collection Period → More Efficient A/R Collection Process
  • Longer Average Collection Period → Less Efficient A/R Collection Process

A business model where only cash is the accepted form of payment would, of course, be the most efficient and increase a company’s liquidity (and free cash flow).

However, acceptance of credit purchases has become the norm across practically all industries, especially among consumers, as confirmed by the prevalence of credit purchases (i.e. credit cards) in the retail space.

The more quickly a company can collect cash payments from customers that previously paid using credit, the more efficiently it operates. Credit arrangements are meant to be short-term should be fulfilled by the customer within a reasonable time frame, or else the company may have to reassess its collection policies.

While an imperfect measure due to the limited information, one method to approximate the percentage of a company’s revenue that is in the form of credit is to divide a company’s accounts receivable balance by its revenue.

Credit Sales Formula

The formula for calculating net credit sales is as follows.

Formula
  • Net Credit Sales = Gross Credit Sales – Returns – Discounts – Allowances

Each of the inputs in the formula is described in more detail below.

  • Gross Credit Sales → Gross credit sales simply refer to all sales where the customer paid using credit.
  • Returns → Returns are the sales lost due to customers returning products.
  • Discounts → Discounts are offered by companies as an incentive to increase the number of transactions, at the expense of lower sales price per unit.
  • Allowances → Closely tied to discounts, allowances stem from events such as defective items or accidental mispricing — and the buyer and seller reach a compromise on a deduction to price.

The average collection period is a metric that measures a company’s efficiency at converting sales on credit into cash on hand.

The average collection period formula is as follows.

Formula
  • Average Collection Period = (Accounts Receivable ÷ Net Credit Sales) × 365 Days

Either the ending or average A/R balance can be used in the formula, but the difference (and the takeaways) are marginal — unless there is a clear shift in the A/R balances due to operational changes.

Another notable metric is the receivables turnover ratio, which estimates the number of times in a year that a company collects its owed cash payments from customers, i.e. it counts how frequently sales on credit was converted into cash.

The receivables turnover is the ratio between the company’s sales on credit and its average A/R balance.

Formula
  • Receivables Turnover = Net Credit Sales ÷ Average Accounts Receivable

Credit Sales Calculator — Excel Template

We’ll now move to a modeling exercise, which you can access by filling out the form below.

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Net Credit Sales Example Calculation

Suppose a company generated $24 million in gross credit sales in 2021.

  • Gross Credit Sales = $24 million

We’ll also assume the following reductions.

  • Returns = -$2 million
  • Discounts = -$1 million
  • Allowances = -$1 million

Thus, the total aggregate downward adjustment to the gross sales made on credit is $4 million, which we’ll subtract from our gross sales of $24 million to arrive at a net amount of $20 million.

  • Net Credit Sales = $24 million – $4 million = $20 million

Credit Sales Calculator

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