Business Credit and Financial Management Fundamentals
Why credit is a financial function
Business credit is the sale of goods or services on open account, converting a sale into a receivable. The credit department manages the trade-off between sales growth and the cost and risk of carrying receivables. Key measures include days sales outstanding (DSO), aging percentages, bad-debt write-offs as a percentage of sales, and the cost of carrying receivables (funding cost plus administrative and loss cost). DSO = (average accounts receivable ÷ credit sales) × days. Use credit sales, not total sales, and match the day count (365 or 360) consistently.
Core rules
- Credit terms price the credit: 2/10 net 30 means a 2% discount for payment by day 10, otherwise the full amount is due by day 30.
- The annualized cost of foregoing the discount = (discount ÷ (1 − discount)) × (365 ÷ (full term − discount period)).
- Working capital = current assets − current liabilities; receivables are a working-capital investment.
- Credit performance is measured with DSO, aging, write-off rate, and cost of carrying receivables.
Worked example
A customer has average AR of $1,200,000 and annual credit sales of $9,000,000. DSO = ($1,200,000 ÷ $9,000,000) × 365 = 48.7 days. With terms of net 30, collections are about 19 days slow. If the customer is offered 2/10 net 30, the annualized cost of not taking the discount is (0.02 ÷ 0.98) × (365 ÷ 20) = 37.2%. The buyer should borrow at less than 37.2% to take the discount; the seller should compare the 2% discount cost with the carrying cost of the extra 20 days.
Traps
Using total sales instead of credit sales in DSO; using ending AR in a seasonal business; ignoring the 365 vs. 360 convention; treating a discount as free; and measuring credit performance only by bad-debt write-offs while ignoring DSO and aging.