What Is the Major Problem With Selling on Credit?

Selling on credit involves a business allowing customers to acquire goods or services immediately and pay for them at a later date. This practice is commonplace across many industries, from wholesale and manufacturing to retail and healthcare. It enables businesses to expand their customer base and increase sales volume by removing the immediate financial barrier for buyers. While offering credit can incentivize purchases, it also introduces inherent financial challenges that businesses must carefully manage.

Uncollectible Accounts

One of the most direct financial challenges of selling on credit is the risk of uncollectible accounts, also known as bad debt. These represent the portion of accounts receivable that a business no longer expects to collect from customers. Such situations can arise due to various reasons, including a customer’s financial distress, bankruptcy, disputes over goods or services, or even fraud.

When an account becomes uncollectible, it results in a direct financial loss for the business, impacting its profitability. Businesses account for these losses as “bad debt expense” on their income statement. This expense reduces the company’s net income and overall profit.

To reflect the true value of accounts receivable on the balance sheet, businesses typically use the allowance method, which is preferred under Generally Accepted Accounting Principles (GAAP). This method involves estimating potential uncollectible amounts and creating an “Allowance for Doubtful Accounts,” a contra-asset account that reduces the total accounts receivable. The estimate is recorded as bad debt expense in the same period as the related revenue, adhering to the matching principle. For example, if a business estimates that 2% of its credit sales will be uncollectible, it records that percentage as an expense, even before specific accounts are identified as uncollectible.

Impaired Cash Flow

Extending credit significantly impacts a business’s liquidity and working capital, even when accounts are eventually collected. When sales are made on credit, the cash from those sales is not immediately available; instead, it is tied up in accounts receivable. This delay means money is not readily accessible for immediate operational needs, such as paying employees, purchasing inventory, or covering overhead expenses.

This delay in cash inflow can create cash flow shortages or gaps, forcing a business to find alternative ways to cover its short-term obligations. For instance, a company might need to draw on a line of credit or other short-term loans to bridge the gap between credit sales and cash collection. Such borrowing incurs interest costs, which further erode profitability.

Unlike cash sales, which provide immediate funds, credit sales transform revenue into a promise of future payment. Efficiently managing the collection process is crucial to converting these receivables into cash and maintaining healthy liquidity.

Increased Operational Costs

Selling on credit introduces various administrative and operational expenses that can significantly affect a business’s bottom line. These costs are incurred specifically to manage the credit process and ensure payment, adding to the overhead of doing business. Effective credit management aims to control these costs while minimizing the risk of non-payment.

Initial costs include credit assessment, where time and resources are spent checking a customer’s creditworthiness before extending credit. This involves evaluating financial stability and payment history to mitigate risk. Once credit is extended, there are ongoing expenses related to invoicing and record-keeping, such as generating and sending invoices, tracking payments, and maintaining detailed accounts receivable records.

If payments become overdue, businesses incur additional costs for collections efforts. This can involve significant time, labor, and communication expenses for sending reminders, making phone calls, and drafting emails to follow up on delinquent accounts. For severely past-due accounts, businesses may need to engage external collection agencies or pursue legal action, leading to further fees. Collection agency fees and legal fees can also be substantial.