Your company may sell products and services on both a cash and credit basis. In the case of the latter, the customer receives the purchased item immediately but pays for it by making payments over time.
When a high percentage of a company's sales occur on a credit basis, the annual credit sales figure – calculated using the annual credit sales formula – signals the importance of a company's ability to convert credit sales to cash. After all, liquidity affects cash flow and cash flow determines if a business can pay its own debts and manage its operations to best support its elected strategy and grow the business.
Benefits of Credit Sales
Assuming the good or service you purchase is a factor of production for your own business, a delay in payments grants you an opportunity to use goods you buy to generate the cash you need to pay for the purchase. In turn, the willingness to sell goods on credit benefits the seller because the delay may allow the customer to make additional purchases. For this reason, credit sales are likely to attract customers to a business.
While consumers may pay cash or make the majority of their purchases using a credit card, it's not unusual for business-to-business transactions, such as those between a manufacturer and wholesaler, to take the form of trade credit sales.
The trade credit is a B2B agreement whereby a customer purchases goods on account and agrees to pay the supplier on or before a scheduled date. Often the credit is extended for 30, 60 or 90 days.
Trade Credit Accounting
Buyers and sellers alike account for trade credits, but their methods differ depending on whether the business is required to use cash accounting or accrual accounting. Public companies must use accrual accounting, which recognizes revenues and expenses at the time of the related business transaction.
Seller of Goods or Services
If your business issues a trade credit invoice, it's likely you'll pay expenses related to the sale before you receive payment for the good or service. Consequently, your company must account for the asset – the trade credit – as an accounts receivable, an assets account that appears on your company's balance sheet.
Because your customer may default or fail to pay the debt, your company might offer discounts as an incentive for a timely payment of the debt. These discounts and the defaults are treated as accounts receivable write-downs or write-offs, which offset a portion of accounts receivable.
Buyer of Goods or Services
If your company buys goods or services, your recognition of the expense is not immediate, but rather occurs at the time the trade credit is paid. Due to this fact, you have a 0 percent loan that doesn't appear on your balance sheet.
What's more, you gain the use of the items purchased, but your cash balance and cash flow remain unphased by the expense until you pay for the item and account for the purchase on your income statement.
Annual Credit Sales Formula
To calculate credit sales, use the annual credit sales formula. First, calculate your total sales, then deduct sales returns from that figure. Next, subtract sales allowances and then cash sales from the current total sales amount and you have your company's annual credit sales.
Calculate Total Sales
Assume that your company's cash sales for 2020 totaled $8 million and your total accounts receivable equals $13 million, which includes the $3 million accounts receivable ending balance for the year 2019.
To calculate your total sales for 2020, you add the cash sales of $8 million to the difference between the total accounts receivable of $13 million and the 2019 accounts receivable carryover of $3 million – $8 million plus $10 million – for total sales of $18 million.
Deduct Sales Returns
Next, assume that in 2020, your company issued $1 million in refunds due to customer returns. The related sales had been purchased using trade credit.
To calculate total sales less sales returns, subtract the $1 million refunds from the $18 million total sales calculated earlier, for the total sales less sales returns figure of $17 million.
Subtract Sales Allowances
Now, assume that sales allowances in the amount of $500,000 had been issued to customers during 2020. These allowances decreased the amounts your customers owed your company, but simultaneously ensured customers retained products, rather than return them for a full refund.
To calculate the total sales less sales allowances for 2020, subtract the sales allowances of $500,000 from the total sales less returns of $17 million for the total sales less sales returns and allowances of $16.5 million.
Subtract Cash Sales
Using the three prior calculations, you calculated your company's total sales net of sales returns and allowances of $16.5 million. You can now calculate your company's total credit sales by deducting your company's cash sales of $8 million from the $16.5 million, for a difference of $8.5 million in total credit sales.