What Are Doubtful Accounts and How to Minimize Them?

Doubtful accounts might be much less in number than bad debt accounts, but treating them as non-essential will impact your business negatively.

Doubtful accounts that have the potential to turn into bad debt will affect the cash flow foundation of your business. In turn, it will affect your profitability, delay investment plans, and so on. When your business continuously ignores doubtful accounts, it can even result in dire consequences.

It is essential to analyze which doubtful account will turn into bad debt. Let’s look at some ways to do it:

1. Historical data analysis

It involves going through your past account receivables statistics to figure out a percentage for doubtful debt.

Suppose you have $200,000 in account receivables in a specific financial period but lose $10,000 to a doubtful debt; you could set the allowance for the doubtful debt at 5% of the total AR for that period.

2. Aging method

A technique used to determine how much of a company’s accounts receivables are past due. The aging method sorts each customer’s unpaid invoices by invoice date into four columns:

• List invoice amounts that are 0-30 days past due in the first column
• In the second column list the invoice amounts that are 31-60 days past due
• The next column should have invoices 61-90 days past due
• The last column lists the invoice amounts that are 91-120 days past due

Assume that a company has $300,000 in accounts receivable. $120,000 of this falls into the 0-30 days bucket, $95,000 is in the 31-60 days category, $55,000 is in the 61-90 days range, and the remaining $30,000 is in the 90-120 days bucket.
From historical experience, the company accountant applies an estimated 4% doubtful debt percentage to the 0-30 days bucket, a 7% rate to the 31-60 days bucket, a 15% rate to the 61-90 days bucket, and a 20% rate to the 91-120 days bucket.
The following formula could be used to determine the amount of doubtful debt for each bucket:

Calculating the doubtful debt for 0-30 bucket, we get:
4/100 x $120,000 = $4,800
So the doubtful debt for the 0-30 bucket is $4,800. Similarly,

• $6,650 doubtful debt falls under the 31-60 days bucket
• In the 61-90 range, the doubtful debt is $8,250, and
• $6,000 of debt in the 91-120 range

This application of the aging method results in an estimated doubtful accounts receivable amount of $25,700.

3. Risk assessment

Another method to determine doubtful accounts is risk assessment. It is explicitly for businesses that deal with a small number of customers and evaluate them individually to determine the risk. Customers are divided into three risk categories: high, medium, and low. According to the level of risk, each group is assigned a percentage of the doubtful debt. The projected tolerance is calculated by multiplying these percentages by the total sales of each category.

For example, Christine works as an accountant for a business, and she wants to segregate six of her long-time customers- A, B, C, D, E, and F, based on the risk they pose. While going through historical data, she found out that:

• A has turned about 5% of AR into doubtful debt
• About 8% of B’s AR has turned into doubtful debt
• C has approximately 3% of its AR converted
• Doubtful debt conversion rate for D stands at about 15%
• Conversion rate for E is about 12%
• About 9% of F’s AR morphed into doubtful debt

Christine can now put the six customers in three different risk categories based on each customer’s estimated doubtful debt conversion rate.

Now, the estimate for doubtful debt could be calculated as follows. Suppose $100,000 is to be collected from all these customers. Based on this risk assessment, you could predict how much of it will turn into doubtful debt. After calculating, you get:

• Low-risk category customers can expect an estimated loss of about $1,000–$5,000 as doubtful debt
• $6,000–$9,000 loss can be forecasted as doubtful debt for medium-risk category customers
• Amount lost as doubtful debt stands at $10,000 or more for the high-risk category customers

This method is not recommended for enterprises because it is difficult to segregate newly onboarded customers into a specific risk category. The fewer the customers, the more effective this process becomes.

Now that you understand how doubtful accounts impact your business, you should also be aware of the practices that could reduce them. Here’s what you need to do.

Financial health checks of your customer

An in-depth survey of the customers’ financial metrics such as liquidity, solvency, profitability, and operating efficiency would help predict their long-term economic sustainability. By doing a credit risk assessment of your prospects, you can be sure that you are working with dependable customers. Running monthly credit assessments of your present clients could be beneficial.

It’s also critical to build good ties with your consumers so that you may efficiently pursue payment. In this case, your sales team might play a key role in establishing a positive relationship.

Automate your accounts receivable processes completely

A reliable AR solution not only helps you predict and track doubtful accounts precisely but also offers statistical data to show how many doubtful accounts you could sustain without financial loss. To deal with late payments, you need to have appropriate processes and policies in place. It’s easier for your consumers to pay you on time if you allow online payments and deliver invoices and reminders promptly. If you do run into late payers, make sure you have a mechanism to deal with such instances without wasting too many resources.

Doubtful accounts, though fewer in number, could turn out to be harmful because they have the potential to affect AR due to their volatile nature. Tackling this is a difficult challenge in itself.
With a reliable AR solution, you get a thorough understanding of a customer, enough to predict the risk of them turning into a doubtful account. Also, you get a well-toned strategy to structure and ensure a smooth cash flow.
Automate your doubtful debt predictions and increase your collections with the RadiusOne eInvoicing & Collections App. HighRadius RadiusOne AR Suite supports AR processing for midsized companies across industries with a complete order-to-cash solution.