Any transaction taking place between businesses has certain terms attached to it. Such business terms may also include the time period offered to a buyer to make payments for the goods bought. That is the aspect that a Credit Period covers.
While the concept may seem quite simple, there are certain peculiarities that make it different from collection and discount periods.
Thus, we explain what a Credit period means, its formula, its advantages and disadvantages, its calculation along with an example, and how it is different from a Collection period while concluding with the importance of it for a company’s working capital cycle.
Credit Period Meaning
A Credit Period is the time period a business grants to its customers to pay for the goods or services bought.
Usually, goods or services sold on credit have a time period for the full and final settlement of the invoice called the credit period. Thus, it may also be considered as the time frame within which a customer pays for the invoice of a transaction.
However, it is not the time taken by the buyer to pay, but the time frame allotted by the business to its buyer in order to make a payment. Thus, if a business gives 10 days to a buyer to make the payment but the buyer pays in 20 days, then the period would be 10 days, and not 20.
In case a business functions on a cash-only basis or has zero credit sales, then the period would be zero.
If the credit terms of a transaction allow for differed or multiple payments, the period is taken as the number of days between the extension of credit and the last payment.
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Components of Credit Period
The Credit Period has three essential components, namely-
Credit Assessment
Credit Assessment entails gauging a buyer’s creditworthiness. Based upon the credit analysis, trend analysis of the buyer, and the company’s credit policies, sales are made on credit terms.
Collection Procedure
It is the procedure a business adopts for the collection of its accounts receivable or unpaid invoices according to the business terms. It includes the policies the business has put in place for recovery, including any interest rate on credit purchases, or any additional fees on late payment.
Sales Terms
Sales terms are credit terms that are defined at the time of sales. It includes the payment term, collection periods, discounts on early payment, etc.
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How do you calculate the Credit Period?
A Credit period is calculated using the following formula:
Credit Period = Credit Days/Receivable Turnover Ratio or Average Accounts Receivable/(Net credit sales/Credit Days)
where
Credit Days are the total days during a specified period, for example- 365 days in a year.
Receivable Turnover Ratio is the Net Credit Sales of a company to its Average Accounts Receivable.
Average Accounts Receivable is the average of the opening and closing balance of the Accounts Receivable of a company, ie. the (Opening balance of the Accounts receivable + Closing balance of the Accounts receivable)/2.
Net Credit Sales is the credit sales of a company during the consideration period.
Credit Period Example
Let us understand how the Credit Period is calculated using an example.
Let us assume that Company A has Net Credit sales of INR 9,00,000 for the year with the opening and closing balance of accounts receivable being INR 80,000 and INR 1,00,000 respectively.
Thus, the Average accounts receivable will be (80,000+1,00,000)/2
= 1,80,000/2
= 90,000
For the fiscal year, the number of days would be 365.
Therefore, the Receivable turnover ratio = 9,00,000/90,000
= 10.
We can now calculate the period using the formula.
Credit period= Credit Days/Receivables turnover ratio
= 365/10
= 36.5 or 37 days.
What this means is that the number of days a company gives to its customers to make payments on its credit sale is 37 days.
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Advantages of Credit Period
A Credit Period has the following advantages or benefits-
- It helps companies to increase their customers by providing trade credit.
- It helps in increasing sales by allowing customers to more time to pay for the goods bought.
- It helps strengthen the relationship between the buyers and the sellers.
- It allows a company to informally check buyers’ creditworthiness.
- For the buyer, it has minimal cash outlay, ie. the buyer pays no interest on the trade credit.
- Ensures uninterrupted supply of goods for the buyer, while increasing accounts receivable for the supplier.
- Buyers may receive huge discounts on early payment as per the sales term.
Disadvantages of the Credit period
A Credit period has the following disadvantages-
- A penalty or fee may be levied on the buyer if the supplier’s payments are not within the given period.
- A longer period may hamper a company’s working capital cycle and lead to inefficiencies in the cash flows.
- A long CP may negatively affect a company’s debtors turnover ratio or accounts receivable ratio.
- It is only the period given by a supplier to the buyers to pay for the goods bought, which may be at variance with the average collection period.
Credit period vs Collection period
While both Credit period and collection period are similar concepts, one is a de jure concept while another is de facto.
A Credit Period is the number of days given by a company to its customer to make payment for the goods bought.
A collection period is the actual time taken by a company to recover accounts receivable. Thus, it is the time a customer takes to make the last payment for the goods bought.
A collection period thus can be longer or shorter than the credit period.
If the customer decides to pay early, the Collection period will be shorter than the credit period.
If the company fails to recover its unpaid invoices within the specific period of the credit term, the collection period will be longer than the credit period.
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How is the collection period different from a discount period?
A collection period is the average time taken by a company to collect its accounts receivable. It may or may not be equal to the credit period provided by the company.
Thus, at times, a buyer may take more time to pay than the company allows for.
To avoid this, most companies provide discounts on early or fast payments. The specific period within which a buyer becomes eligible for a discount on early payment is called the discount period.
Final Words: Importance of Credit Period
The significance of the Credit period can be gauged from the prevalence of credit sales in any industry. Most suppliers offer goods on credit arrangements to increase their revenue. On the other hand, it offers buyers an uninterrupted supply of goods without having to take a working capital loan to make payments.
Within this interconnected supply chain, it ensures that a lag anywhere in the system does not interrupt the operations of others.
Thus, a credit policy elucidating the period a business offers to its customers for making payments for the purchases made has a bearing on its working capital cycle, and its general business health.
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FAQs
1. How do you calculate the credit period?
The Credit Period is calculated by dividing the number of days in a specified period by the receivable turnover ratio.
On the other hand, it could also be calculated by dividing the product of average accounts receivable and credit days by the net credit sales.
2. What is a 30-day credit period?
A 30-day credit period means that a business allows its customers to make payment for the goods bought in 30 days.
3. What does a longer credit period mean?
A longer credit period means that a company allows its accounts receivable to stay outstanding for a long time. Thus, a longer period is the period a business allows its customers to pay for the purchases made.
4. What is a credit period of one month?
A credit period of one month means that buyers have to make payment to the supplier for the goods bought within one month of the credit sales.
5. What is the meaning of credit days?
Credit days, or Credit period is the time period given to a buyer to settle outstanding balances on sales made on a credit basis. It is different from the collection period, which is the time taken for the collection of the accounts receivable.
6. What are credit terms?
Credit terms are the terms and conditions of sales made on credit basis which include the payment schedule and the period allotted to the buyer to make payment for the goods bought.
