Debt is an inevitable facet of the business world; though it often has a negative connotation, it plays a pivotal role in driving business growth and expansion.
However, it becomes a problem when these debts convert into bad debts and hinder your business’s progress and financial stability. The key to safeguarding your business from the pitfalls of bad debt lies in effectively managing your debts, as they often occur due to poor financial management.
In this comprehensive article, we will explore every aspect of bad debt, equipping you with the knowledge and strategies to avoid it and manage your business’s finances. To get started, keep reading or jump to the section you’re looking for.
Bad debt refers to the amount of money owed by customers that are unlikely to be collected due to various reasons, such as the customer’s financial difficulties, insolvency, or refusal to pay. When a debt is deemed uncollectible, it is written off as a loss on the company’s financial statements, impacting profitability.
Managing bad debt is crucial for maintaining financial stability. Though it’s a natural risk associated with extending credit, it needs to be tracked regularly, as excessive bad debt can weaken a company’s financial standing. When preparing their tax returns, businesses can write off bad debt credits, reflecting the uncollectible nature of these outstanding payments.
Bad debts hold significant importance for the following three reasons:
Bad debt expense is the cost a company incurs when a customer fails to pay what they owe. It represents the amount of money that the business expects to lose from unpaid invoices. This expense is recorded in the financial statements to reflect potential losses from uncollectible accounts.
Think of it like lending money to a friend who promises to repay you but never does. Eventually, you accept that the money is gone, and you count it as a loss. Similarly, businesses acknowledge bad debt when they realize certain customers won’t be able to pay.
To illustrate the concept of bad debt, consider this example: XYZ Manufacturing provides raw materials on credit to Building Solutions Inc., a construction company, for a large project.
However, due to unforeseen project delays and financial challenges, Building Solutions Inc. faces difficulties in paying their outstanding invoices on time.
Despite multiple attempts to collect the overdue payments, XYZ Manufacturing is unable to recover the $50,000 owed.
As a consequence, the $50,000 owed by Building Solutions Inc. becomes bad debt for XYZ Manufacturing. Consequently, they record the uncollectible amount as a loss in their financial records.
Businesses can find their bad debt expense in two ways. The first one is “Direct Write-Off,” and the second is the “Allowance method.”
In this technique, the bad debt is directly considered as an expense, and the debt ratio is calculated by dividing the uncollectible amount by the total Accounts Receivables for that year.
This is an easy method for bad debt calculation, but it is not very accurate. It can only be applied when there is a confirmation that an invoice won’t be paid for, which takes a lot of time. The method also doesn’t align with the GAAP accounting standards and the accrual accounting matching principle. Direct Write-offs are more suitable for small transactions.
The allowance method is used to manage bad debt in businesses that rely heavily on credit sales. By estimating bad debts before they occur, companies can maintain an allowance for doubtful accounts in a contra asset account. The specific amount is determined based on the company’s past records and individual circumstances.
To calculate bad debt using the allowance method, there are two distinct approaches:
The first method involves determining the bad debt rate by analyzing historical data. This rate is calculated by dividing the total bad debts by either the total credit sales or the total accounts receivable.
% of Bad Debt = Total Bad Debts / Total Credit Sales (or Total Accounts Receivable)
Once the bad debt rate is determined, it is applied to the current credit sales. For example, if the bad debt rate is 1%, 1% of the current credit sales would be allocated to the bad debt allowance account.
Another method for estimating bad debt is through the utilization of the account receivable aging technique. This approach relies on an aging report that classifies invoices based on their age, such as those overdue by 0 to 30 days, 31 to 60 days, 61 to 90 days, and so forth.
It is crucial to assign specific percentages of bad debt to each aging category. Generally, the longer an invoice remains unpaid, the lower the likelihood of it being settled. For instance, a 1% bad debt allocation could be assigned to invoices overdue by 0 to 30 days, while a higher percentage, such as 30%, might be assigned to invoices that are past 90 days.
To calculate the projected bad debt using the account receivable aging method, you need to determine the total amount of accounts receivable in each aging category and apply the corresponding bad debt percentages. By summing up these amounts, you can ascertain the overall total of anticipated bad debts, which can then be allocated to the allowance account.
To record bad debt expense, follow these steps:
The bad debt ratio measures the amount of money a company has to write off as a bad debt expense compared to its net sales. In other words, it tells you what percentage of sales profit a company loses to unpaid invoices.
A high bad debt ratio can indicate that a company’s credit and collections policies are too lax, or it may suggest that the company is having trouble collecting customer payments. With B2B businesses relying on the credit model to bring in more clients and sales volume, bad debt has become an inevitable part of operations.
“In Europe and North America, non-collectible written-off revenues had risen to 2% before the pandemic,” says a McKinsey article. It is a worrisome sign if the bad debt rate (the ratio of bad debt and AR in a year) is too high. On the surface, the reason behind it might seem to be limited only to the client, but how a company handles its AR also plays an important role.
The bad debt to sales ratio represents the fraction of uncollectible accounts receivables in a year compared to total sales. For example, if a company’s revenue is $100,000 and it’s unable to collect $3,000, the bad debt to sales ratio is (3,000/100,000=0.03). This metric provides valuable insights into a business’s cash flow, the efficiency of its AR and collection processes, and overall financial health.
By closely monitoring the bad debt-to-sales ratio, your business can formulate better credit terms, reduce uncollectible AR, and maintain a healthy cash flow. As we delve into these strategies, it’s worth noting that a comprehensive understanding of credit risk extends beyond individual businesses. If you’re interested in exploring how 100 Fortune 1000 companies manage their provision for credit loss to sales ratio, particularly in industries such as healthcare, manufacturing, utility, and technology, check out our in-depth analysis.
Before we get into the ways to prevent and reduce bad debts, it’s important to understand why bad debts happen. Every business is different, but the following are some common reasons that contribute to bad debts in various industries.
Understanding these challenges can help companies tackle the root causes and minimize the impact of bad debts on their financial health. Here are some prevalent issues that often lead to bad debts:
Here are a few tips for managing your bad debt expense:
By implementing these strategies, businesses can improve their accounts receivable management, reduce bad debts, and maintain a healthy financial position.
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The bad debt expense formula depends on the method used:
This method estimates bad debt based on a percentage of total sales.
Bad Debt Expense = Total Sales x Estimated Percentage of Uncollectible Sales
This method categorizes accounts receivable by age and applies different uncollectibility percentages to each group.
Bad Debt Expense=∑(Accounts Receivable by Age Group x Estimated Uncollectible Percentage)
The accounting equation for bad debts is:
Assets = Liabilities + Equity
Recording bad debt decreases assets (Accounts Receivable) and reduces equity (Bad Debt Expense).
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