What Is the Major Problem With Selling on Credit?

Selling on credit involves a business delivering goods or services to a customer with the understanding that payment will be made at a later date. While this practice can attract customers and increase sales, it introduces challenges that impact a company’s financial health. Businesses extending credit must navigate complexities arising from delayed payment cycles.

The Risk of Non-Payment

The primary challenge with selling on credit is the risk that customers may not fulfill their payment obligations. When a customer fails to pay, the amount owed becomes “bad debt.” This represents a financial loss for the business, as recorded revenue is never collected. The impact is a reduction in a company’s reported revenue and overall profitability.

Businesses often establish an allowance for doubtful accounts, an estimate of receivables they expect will become uncollectible. This accounting provision helps reflect the realistic value of accounts receivable on the balance sheet. Despite these provisions, uncollected debt means the costs incurred to produce or acquire goods and services, along with the expected profit margin, are lost. This intrinsic risk must be carefully managed to prevent financial setbacks.

Implications for Cash Flow

Even when customers eventually pay, selling on credit creates challenges for a business’s cash flow. Cash from these sales is not immediately available; it is tied up in accounts receivable. This delay means funds cannot be readily used for operational expenses, such as paying suppliers, covering payroll, or investing in new inventory. Extended payment terms create a gap between when expenses are incurred and when revenue is received.

This delay in cash inflow can lead to liquidity challenges, potentially forcing a business to seek short-term financing, such as a line of credit, to cover its obligations. Relying on external financing incurs additional costs, including interest payments and fees, which erode profitability. Delayed cash availability can hinder ability to capitalize on growth opportunities or respond quickly to market changes, as capital remains inaccessible.

Operational Expenses

Managing credit sales introduces operational expenses. Administrative costs are associated with maintaining accounts receivable, including generating invoices, recording payments, and reconciling customer accounts. These activities require personnel and specialized accounting software, adding to overhead. Before extending credit, businesses incur costs for credit checks and customer vetting to assess a client’s creditworthiness. This process involves obtaining credit reports from agencies, which often come with a fee, and dedicating staff time to review financial histories and references.

If accounts become overdue, businesses bear collection costs, including sending reminder notices, making phone calls, and engaging third-party collection agencies or pursuing legal action. Collection agencies typically charge a percentage of the amount collected, and legal fees can be substantial if a lawsuit is initiated. The time and resources dedicated to managing the credit process represent an opportunity cost, as these resources could otherwise be focused on core business development or customer service activities that directly generate revenue.