Many firms,however,make a significant portion of their sales on credit. They do so because customers prefer deferring their payments. Credit transactions enable purchasers to use their cash for a longer period of time before paying the seller. Moreover, credit transactions permit the purchaser to inspect and actually use the goods prior to payment. Industry practices and competitive pressures force many firms to sell on credit, and credit sales to customers in the ordinary course of business give rise to accounts receivable (trade receivables).
Before making a credit sale, the credit standing of the customer should be assessed. Credit-worthiness is an important consideration in making a credit sale because it bears directly on a potential customer’s ability and willingness to ultimately make payment. Various credit bureaus (such as Dun & Bradstreet and Equifax) provide credit ratings and other information for this purpose.
Selling only to customers with high credit ratings, however, will not necessarily maximize profits. Although such a policy would minimize receivables that prove to be uncollectible, a number of potentially profitable sales might be eliminated and the profit on these sales may well overshadow the expense of uncollectible accounts. Thus, a firm must decide how much credit to grant and to whom credit should be offered. Selecting a credit-rating cutoff in some middle range is probably optimal.