Bad debt is an irrecoverable sum of money written off as a loss and covered under expenses. It occurs when clients cannot pay back a company due to bankruptcy or scams. Or, when any additional efforts to recover the Account Receivable(AR) become more expensive than the AR itself.
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 a significant role.
A high bad debt rate is caused when a business is not effective in managing its credit and collections process. If the credit check of a new customer is not thorough or the collections team isn’t proactively reaching out to recover payments, a company faces the risk of a high bad debt.
Let’s look at the main reasons that lead to high bad debt in companies and how they can overcome these challenges.
Businesses that rely on manual credit checks find it challenging to maintain real-time visibility in the credit health of clients. It leads to overlooked information which culminates in unrealistic credit limits for their clients. Therefore, the chance of bad debt increases. Credit managers can avoid it by automating credit checks and regularly updating clients’ credit limits.
It can take up to 25 days to process a single invoice manually. The inefficient approach to managing invoices can also affect the collections process. It gets even more difficult for larger businesses due to the massive volume of invoices, resulting in high Days Sales Outstanding (DSO) and subsequent delinquent customers. Implementing e-invoicing in your business can help you get paid faster and also reduce your bad debt.
If your collection process is reactive, the chances of facing delinquency from customers increase significantly. It’s because you wait for a client to default on their payment before taking any action. This approach also reduces the chances of recovery. Instead, having a proactive approach where at-risk clients are identified and approached beforehand can reduce bad debt and improve DSO.
Businesses that don’t offer incentives on early payments lose out on an easy way to boost collections. A small discount can go a long way in appreciating and encouraging your clients to pay on time or even in full beforehand. For example, A company can offer a 1% discount to clients paying in full while placing an order and a 0.5% discount if they pay before the credit period ends.
Bad debt calculation can be done by businesses using two primary methods. 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.
It is a more advanced accounting method for keeping track of bad debt. Here, bad debts are estimated even before they happen. An allowance for doubtful accounts is always maintained in a contra asset account. The amount of this allowance will depend on the company and its past records.
Now, this is the forecasted bad debt in a contra-asset account for the next year. Depending on the method used to calculate the bad debt, a debit is made to the allowance account and credit to the Accounts Receivables whenever a bad debt is incurred.
There are two main estimation techniques to calculate a company’s bad debt for a particular year. They are:
It is a basic method that estimates bad debt based on a business’s total sales and previous data. If it is predicted that 3% of the total sales of a business will be uncollectible and the net sales are $1,000,000, then the allowance will be 3% of $1,000,000, i.e., $30,000.
In this process, aging methods are used to estimate bad debt. An aging chart can be prepared based on an organization’s previous data and records. The chart shows what percentage of AR is uncollectable after a particular period.
For example, the uncollectable amount can be 2% for 1-30 days due account and 5% for 30-60 days due, and so on.
Bad debt can be calculated based on the total AR, different clients, and their past dues. After that, it will be adjusted with the allowance balance, and the bad debt expenses will be registered.
The bad debt to sales ratio is the fraction of an organization’s uncollectible accounts receivables in a year and its total sales.
For example, company A is making $100,000 in revenue every year and is unable to collect $3,000. So, the bad debt to sales ratio is (3,000/100,000=0.03).
This metric gives a clear insight into a business’s cash flow, the efficiency of its AR, collection processes, and overall health. Keeping a close eye on the bad debt to sales ratio will help your business formulate better credit terms and reduce uncollectible AR. Additionally, keeping a low ratio will improve your business’s credit score and enable you to maintain a healthy cash flow.
Manual processes lead to inefficient credit scoring, reduced real-time visibility into customer credit health, and slow reactive collections. This results in poor cash flow and high bad debt to sale ratio. By automating a business’s credit and collection processes, all of these problems can be easily mitigated. It will boost profits, reduce DSO and keep bad debt at the lowest.
Although bad debt shows up on the balance sheet, it is in a contra-asset account. This means that the Accounts Receivables will be credited on the debit section of the bad debt account.
When a bad debt is written off, it is considered an expense and removed from the Accounts Receivable tab of the balance sheet. It means a company is acknowledging that the AR is no longer recoverable and a loss has occurred.
Debts that are no longer recoverable and written off as losses/expenses are called bad debt. For example, loans from banks and sales made on credit can be categorized as bad debt.
Bad debt rate is the percentage of bad debt that a company writes off as an expense or loss using the direct write-off or allowance method.
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