Bad Debt: What Is It, How to Calculate, and Tips for Managing It

Introduction

Debt is an inevitable facet of the business world, serving various purposes for both lenders and borrowers. Though there is often a negative connotation associated with debt, it plays a pivotal role in driving business growth and expansion. 

However, it becomes a problem when these debts convert into bad debts and hinders the progress and financial stability of your business. 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 delve into every aspect of bad debt, equipping you with the knowledge and strategies to steer clear of it and get a grip on your business’s finances. To get started, keep reading, or jump to the section you’re looking for.

What Is Bad Debt?

Bad debt represents the financial loss that a business incurs when customers fail to repay credit or outstanding balances. This can happen due to various reasons, such as negligence, financial crises, or bankruptcy.

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:

1. Identifying and addressing bad debts allows businesses to minimize financial losses. By promptly acknowledging uncollectible amounts, companies can take appropriate actions to safeguard their financial stability.Insight into 
2. Monitoring bad debts provides valuable insights into a business’s credit management and financial health. High levels of bad debt may signal the need for improved credit policies and customer evaluation processes.
3.  Understanding the extent of bad debts empowers businesses to make informed decisions regarding credit extension, risk management, and strategies to optimize revenue collection. This knowledge aids in creating a more resilient financial structure.

Example: Bad Debt

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.

What Is Bad Debt Expense?

Bad debt expense is an accounting term that refers to the estimated amount of uncollectible debts that a business is likely to incur during a given period. It is recorded as an expense on a company’s income statement and is deducted from the revenue to arrive at the net income.

How to Calculate Bad Debt Expense?

Businesses can find their bad debt expense in two ways. The first one is “Direct Write-Off,” and the second is the “Allowance method.”

1. Direct write-off 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.

2. Allowance method

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:

1. Percentage of bad debt:

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.

2. Account receivable aging method:

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.

What Is Bad Debt Ratio and How to Interpret It?

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.

Why Is It Essential to Track the Bad Debt to Sales Ratio?

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.

Why Do Bad Debts Happen?

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:

1. Poor Credit Policies: Inadequate credit policies can result in extending credit to customers who may not have the financial capacity to repay their debts.
2. Inadequate Credit Checks: Failing to conduct thorough credit checks on customers can lead to offering credit to high-risk individuals or businesses.
3. Lax Collections Process: A lenient collections process can cause delays or difficulties in collecting payments from customers, resulting in bad debts.
4. Disputed Invoices: Disputes over invoices or unclear billing practices can lead to delayed or unpaid payments, contributing to bad debts.
5. Customer Dissatisfaction: When customers are unhappy with the product or service they received, they may refuse to pay for it, resulting in bad debts.
6. Customer Bankruptcy or Insolvency: Some customers may face financial hardships or even bankruptcy, making it challenging for them to fulfill their payment obligations.
7. Economic Downturns: During economic downturns, customers may face financial challenges, making it difficult for businesses to recover their debts.
8. Lack of Communication: The AR Disconnect is a primary cause of bad debts, arising from a lack of communication between AR departments and customers due to disconnected systems. This miscommunication results in AR teams being out of sync with customer needs, leading to increased bad debt.

How to Prevent and Reduce Bad Debts?

Here are a few tips for managing your bad debt expense:

1. Conduct Robust Credit Assessment: Before extending credit to any new customers, ensure their financial stability and creditworthiness by conducting thorough credit checks.
2. Create Clear Credit Policies: Establish clear and comprehensive credit policies that outline credit limits, payment terms, and consequences for late payments.
3. Proactive Collections Process: Instead of waiting for clients to default on payments, adopt a proactive collections approach. Identify at-risk clients beforehand and take early action to reduce days sales outstanding (DSO) and bad debt.
4. Offer Early Payer Discount: Encourage timely payments by offering incentives like early payer discounts. A small discount can motivate clients to pay on time or even before the credit period ends, ultimately boosting collections and minimizing bad debt.
5. Negotiate Payment Plans: In cases where customers are facing financial difficulties, work with them to establish feasible payment plans to gradually settle their debts.
6. Build Strong Relationships: Establishing strong relationships with customers can foster loyalty and trust, encouraging them to prioritize timely payments.
7. Credit Monitoring: Leverage automation to continuously monitor customer credit profiles to stay informed about any changes in their financial situation that may affect their ability to pay.
8. Real-time Customer Credit Health Visibility: To avoid bad debts, businesses can automate credit checks and regularly update clients’ credit limits for real-time visibility into their credit health. This prevents unrealistic credit limits and reduces the chance of bad debt.
9. Automate Invoicing: Implementing e-invoicing can significantly reduce processing time, helping businesses get paid faster and reducing the risk of bad debts caused by manual invoicing inefficiencies.

By implementing these strategies, businesses can improve their accounts receivable management, reduce bad debts, and maintain a healthy financial position.

Wrapping up - Automation is the Key to Reducing Bad Debts.

Managing bad debts is crucial for maintaining a healthy financial position and safeguarding profits. However, minimizing bad debts is not easy unless you optimize your collection process, and this can be achieved by leveraging automation. 

By embracing automation, businesses can proactively address potential bad debts, identify at-risk customers in real-time, and take timely actions to recover outstanding debts. This optimized approach not only reduces bad debt expenses but also strengthens financial stability, ultimately leading to improved profitability and long-term business success.

Discover smart advice from one of our clients, Yaskawa America, who achieved zero bad debt by leveraging automation. Automation played a crucial role in Yaskawa’s success, providing better visibility, secure payment processing, reduced manual workload, and cost optimization. Download this case study for free and learn how you can implement similar strategies to reduce bad debts and improve your financial stability.

FAQ's

What is the bad debt expense formula?

To calculate bad debt expenses, divide your historical average for total bad credit by your historical average for total credit sales. This formula gives you the percentage of bad debt, which represents the estimated portion of sales deemed uncollectible.