Limit credit risk concentration: Leading companies diversify their credit risk and use dashboards to track the concentration of AR with one customer or a group of customers. They also mention in their financial filings if any customer holds more than 10% of their AR.
Periodic credit risk check-ups: Evaluating customers’ financial conditions periodically using third-party data and credit risk modelling tools is another best practice followed by companies with a low bad debt to sales ratio.
Strong credit controls: Several companies ask customers to provide letters of credit and bank guarantees to prove their creditworthiness. Online credit applications have to be correctly submitted before customers can be onboarded.
Credit risk prediction and management: Real-time credit risk monitoring along with robust models to predict customer payments and delinquency helps manage bad debt better. The models use a variety of inputs including macroeconomic conditions, past payment behavior, credit ratings, etc. It also ensures adherence to the credit policy of the company.
Electronic workflows: Streamline customer data collection, approvals, and onboarding with electronic workflows. It enables accurate data transfer, and faster completion of tasks. It helps make better credit decisions faster while offering customers a seamless experience.
Proactive collections: While strong credit risk management solves collection challenges to a large extent, most companies also have dedicated collection teams to follow up with customers and manage their grievances. They also offer self-service portals to enable customers to make payments, download invoices, and track credit limits.
Grow fast but not at the cost of bad debt
The average revenue for Fortune 1000 companies grew 20% in 2022 YoY. Despite this, their bad debt to sales ratio increased marginally, from 0.15% in 2021 to 0.16% in 2022**.
This is an indicator of their robust credit risk management and collections policies. Their clout as large players may also be enabling them to flex their 'collection muscles'.
Some of the companies also mention using AR factoring to achieve their cash flow targets and minimize write-offs. AR factoring involves selling past-due invoices to third-parties at a discount to get immediate cash.
Industry-wise analysisHere's an industry-wise look at bad debt to sales ratios in 2022 and 2021.
|Average bad debt to sales ratio|
The technology sector had a boom during the pandemic. But it seems to be facing an issue with its receivables as markets take a downward turn. While revenues grew 10% in 2022 YoY, the average bad debt to sales ratio also grew at a similar pace - 11%.
Also, the range (difference between the max to min value) of the ratio was higher compared to other industries. A few players in the industry are having more challenges with their receivables than others.
The consumer packaged goods industry recorded sluggish growth in 2022 (4.3% YoY). Its bad debt to sales ratio remained steady at around 0.05% - 0.06% during both the years. Despite supply chain pressures and inflation, CPG businesses have been able to stand their ground on receivables so far.
The manufacturing industry reported steady bad debt to sales ratio in 2022 and 2021. While their average revenue grew 34%, the bad debt to sales ratio increased only marginally (3%).
The collection moratoriums issued by regulators had forced healthcare & life sciences businesses to temporarily suspend their collections during the pandemic years. This impacted their bad debt expenses and write-offs during 2020-22.
While the revenues grew 10%, the average bad debt to sales ratio grew at double the pace (22%). The range of the bad debt to sales ratio for the industry was also higher, indicating disparities in healthcare companies’ ability to collect.
Utility comprises businesses involved in the distribution of power, natural gas, and water. Regulatory moratoriums suspending collections affected the utility industry receivables in 2020 and 2021. The rising energy prices and job losses are reasons for higher delinquency today.
An S&P report mentions that bad debt is a pressing problem for the utility sector with unpaid bills doubling since pre-COVID times. Revenues climbed 17% in 2022 YoY. The bad debt to sales ratio also grew at a slightly higher pace (18%).
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Preparing for more uncollectibles in 2023 with higher allowance for credit losses
The allowance for credit loss is an estimate of the accounts receivable value that the company is unlikely to recover.
From 2023, companies have to adhere to the new accounting standard - current expected credit loss (CECL) - set by FASB. With the new standard, companies will have to set the allowances based on expected losses rather than incurred losses.
This allowance is a good indicator of bad debt or uncollectibles for the coming financial periods.
2022 vs 2021
In 2022, the average allowance for credit loss to AR ratio was 2.3%. In 2021, the average was slightly lower at 2.2%.
The minimum and maximum allowance ratio values also increased by 20 basis points. Companies have generally increased or maintained the same credit loss allowance to AR ratio in 2022.
|Allowance for credit loss to AR||2021||2022||Trends|
This suggests that companies are bracing up for higher uncollectibles in 2023 compared to 2022. The threat of recession would likely be the key reason behind this.
Here’s a snapshot of how the average allowance for credit loss to AR ratio has changed for different industries between 2022 and 2021.
|Average allowance for credit loss to AR ratio|
The average allowance for credit loss to AR ratio increased for the tech industry from 2.1% to 2.3% in 2022. The median value reduced slightly during the same period. This indicates that some tech companies are going to have more severe bad debt trouble than others.
The CPG industry has maintained the same level of allowance for credit loss in 2022 and 2021. Consumer spending in the US hasn’t taken a big hit in 2022 and H1 2023 despite the rising prices. This is likely keeping CPG companies optimistic about their receivables’ health.
The manufacturing industry has maintained a steady credit allowance to AR ratio (1.9%) between 2022 and 2021. There does not seem to be much issue with receivables in the manufacturing sector.
The worst of the uncollectibles seems to be behind for healthcare companies. The credit allowance to AR ratio remained constant at 3.9%, while the median declined slightly.
Bad debt across utility companies is expected to remain higher in 2023 vs 2022. The allowance for credit loss to AR ratio increased to 2.2% in 2022 from 1.5% in 2021. The median value also increased to 0.87% from 0.84%, indicating that most utility businesses will face pressure on their receivables.
Tackling the rising bad debt challenge
Along with higher interest rates, rising bad debt will pose a challenge for businesses globally in managing their cash flow in 2023.
Benchmark yourself against the ratios we discussed in this report and follow credit risk management and collection best practices to minimize write-offs.
We analyzed the SEC filings of 100 companies from the Fortune 1000 list to identify bad debt values, bad debt to sales ratios, and allowances for credit losses. The 100 companies were randomly chosen from clusters of 100 each according to ranking.
** With some outliers, the bad debt to sales ratio increased by 39% to 0.25% in 2022.