A survey states that organizations write off 1.5% of their receivables as bad debt. Then the question arises, “How would Bad Debt to Sales heal your Credit Health?”
This blog would answer this question for you but let us go through some basic fact check before answering the question.
Bad Debt to Sales is the ratio which shows the percentage of accounts receivable which cannot be recovered from the customers. Companies often refer to Bad Debt as a cost of doing business. It is preferable to have a lower Bad Debt to Sales ratio.
For instance, if an organization is selling approximately €5 million as credit sales, and within this, €100,000 could not be collected at all. So, the Bad Debt to Sales is calculated as:
Bad Debt to Sales = 100,000/5000000 = 0.02
Calculate your bad debt here
Deep diving through this metric is necessary to analyze how a company’s Credit department is functioning. Poor Credit Management could lead to a higher ratio of Bad Debt to Sales, and to compensate this, the Sales team needs to work hard to make sure that they recover those write-offs with revenue from the upcoming orders.
A higher Bad Debt to Sales ratio could be a result of the following actions:
Imagine extending the credit limit or payment terms for a customer who has previous records of delinquency. The high-risk customers would grab this opportunity to delay their payments, and such flexible credit policies and payment terms could lead to a higher Bad Debt to Sales ratio. It is recommended to have a thorough customer risk analysis before onboarding the customer as well as before granting a credit limit extension.
The Credit and Collections team should be able to handle the customers of various risk profiles. The traditional, generalized Collections approach would not necessarily work for all customers, so it is ideal to segment them into various risk categories and tailor the Collections strategies based on their payment behavior, delinquency.
If some of your high-profile customers get bankrupted or show tendencies to get bankrupted soon, it is difficult to collect the outstanding amount from them as you need to maintain the rapport. If you are onboarding customers without analyzing their risk profile or the possible chances of bankruptcy, there are higher chances of experiencing a higher Bad Debt to Sales ratio. In such cases, it is better to sketch down a consolidated payment plan to retrieve the maximum amount from the bankrupted customer.
Bad Debt to Sales ratio could be optimized if the Credit and Collections team go through a basic back calculation and figure out the possible reasons for such a high percentage. The following tips could be helpful while analyzing the possible reasons:
It is recommended to set up a Bad Debt Allowance based on the percentages of Bad Debt in the previous quarters or fiscal years. Marking this limit is necessary to track and analyze the rise or fall of the Bad Debt to Sales ratio. Usually, organizations try to minimize their Bad Debt to Sales ratio by keeping a lower Bad Debt allowance which would continuously push them to lower the Bad Debt percentage to achieve their goals.
It is recommended to have an account-level Bad Debt to Sales ratio calculation. Through this, the senior management would be able to have a better understanding of the delinquency patterns, customer risk categories. For instance, the following graph will give you a better understanding:
Also, the Bad Debt Allowance could be set up account-wise based on customer financial reports, credit risk analysis. Organizations write-off certain bad debts every year, however, they should define the write-off threshold precisely across industries, mentioning what conditions served for the write-off.
The Credit and Collections teams should figure out strategies to fast-track the Collections process. These strategies should be based on customer promise-to-pay analysis, payment date predictions, customer risk analysis, prioritization. Collections analysts should send proactive reminders and do regular follow-ups to get paid faster.
Sales team closing more deals and generating revenue is the best option to recover from a higher Bad Debt ratio. The A/R teams should enhance their internal communication with Sales teams so that the Sales folks could actually jump in when the Credit and Collections analysts are facing issues to collect from a customer.
Credit insurance is the best resource to provide a safeguard against potential risks such as customers getting bankrupted. It is applicable to a certain number of customers against which the insurance would be provided. Bankruptcy is an extreme case when it is difficult to collect from a customer, and this is where Credit Insurance acts as a savior.
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