Healing Credit Health With Bad Debt

What you’ll learn

  • Understand how bad debt affects sales.
  • Understand how to calculate Bad debt to sales.
  • Recognize effective practices to heal credit health.

How Could Bad Debt to Sales Heal your Credit Health?

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.

How is Bad Debt to Sales calculated?

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.

How Bad Debt to Sales increases?

A higher Bad Debt to Sales ratio could be a result of the following actions:

  • Flexible Credit policies

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.

  • Implementing the “Same Size Fits All” Collections Strategies

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.

  • Critical Customers Getting Bankrupted

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.

Best Practices to heal Credit Heath With Bad Debt to Sales

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:

  • Figure Out a Bad Debt Allowance

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:

Bad debt to sales calculation account wise

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.

  • Collect Proactively

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.

  • Motivate the Sales Team to Actively Participate

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.

  • Opt For Credit Insurance

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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HighRadius Credit Software automates the credit management process, enabling credit managers to make highly-accurate credit decisions 2X faster and enable faster customer onboarding with 4 primary components: configurable online credit application, customizable credit scoring engines, credit agency data aggregation engine, and collaborative credit management workflow. Along with that, there are a lot of key features that should definitely be explored some of which are online credit application, credit information aggregation, automated credit scoring & risk assessment, credit management workflows, approval workflows, and automated bank & trade reference checks. The result is faster customer onboarding, better internal collaboration, higher customer satisfaction, more targeted periodic reviews, and lower credit risk across the company’s customer portfolio.