Bad debt is a significant challenge for businesses, affecting their financial health and stability.
It refers to receivables that cannot be collected due to reasons like customer bankruptcy or financial difficulties.
In 2022, the average bad debt to sales ratio for enterprise businesses was 0.16%. Top performers reported ratios as low as 0.02%, while bottom performers hit 1.10%.
For a $1 billion company, a 0.16% bad debt ratio means $1.6 million in lost revenue, and improving this by just 10% could save around $160,000.
Several sectors experienced increases in bad debt ratios due to macroeconomic conditions, with the tech, healthcare, and utilities sectors notably affected.
The average allowance for credit loss to accounts receivable ratio also rose to 2.3% in 2022, up from 2.1% in 2021, indicating higher expected uncollectible debts in 2023.
To combat bad debt, businesses must implement robust credit policies and effective collection practices.
The rise of e-commerce has also increased exposure to bad debt, making it crucial for companies to adopt advanced technologies and practices to mitigate these risks.
In this blog post, we will discuss the term bad debt in detail, its impact on financial statements, and practical strategies for managing and reducing it.
Bad debt arises when a company extends credit to customers who, for various reasons, fail to fulfill their payment obligations. These receivables are deemed uncollectible and are written off as bad debt expenses.
This can result from various situations such as bankruptcy, prolonged financial hardship, or fraudulent activities.
When a debt is classified as bad, it means the company has determined that the likelihood of collecting the amount owed is minimal to none, and therefore, it must be written off as a loss.
Examples of Bad Debt:
- A customer who files for bankruptcy and cannot pay outstanding invoices.
- An individual who purchases goods on credit but experiences a significant financial setback, rendering them unable to settle their debt.
- A company that intentionally defaults on payments, having committed fraud.
For businesses, good debt is an investment that can generate future income or increase the value of assets. Good debt helps businesses grow and expand, leading to higher revenues and profitability.
Examples of good debt for businesses include:
- Taking out a loan to open a new location or invest in new equipment can increase production capacity and sales.
- Investing in research and development can lead to new products or improvements that drive future revenue.
- Purchasing commercial property can be a good debt if the property appreciates in value or generates rental income.
These types of debt are considered beneficial because they contribute to the growth and profitability of the business, often yielding returns that exceed the cost of the debt.
Bad debt, in contrast, does not offer any future benefits and results in a financial loss. It is typically associated with non-productive assets or expenses that do not generate income.
For businesses, bad debt often arises from extending credit to customers who fail to pay, resulting in uncollectible receivables.
Examples include:
- When customers default on payments for goods or services provided on credit, the amounts owed become bad debt, impacting the company's cash flow and profitability.
- High-interest debt incurred for non-essential expenses can quickly become unmanageable, leading to financial strain without contributing to business growth.
- Borrowing to purchase items that do not enhance business operations or generate revenue, such as luxury office decor or non-essential vehicles, can burden the company with unnecessary debt.
Several common reasons can lead to debts become uncollectible:
- Financial Difficulties of Customers: Customers may face financial challenges that render them unable to pay their debts. This instability can stem from personal financial crises, economic downturns, or changes in their business operations.
- Bankruptcy: When a customer declares bankruptcy, they are legally relieved from paying certain debts, which often results in those debts being written off as bad debt by the creditor.
- Poor Credit Management: Ineffective credit policies and inadequate credit checks can increase the risk of extending credit to customers who are likely to default. Businesses that fail to regularly monitor the creditworthiness of their clients may find themselves with higher instances of bad debt.
- Fraudulent Activities: Some customers might engage in fraudulent practices, obtaining goods or services with no intention of paying for them. This can be particularly challenging to prevent and manage.
- Economic Factors: Broader economic issues, such as recessions or sector-specific downturns, can increase the likelihood of bad debts as more customers struggle to meet their financial obligations.
Bad debt must be recognized as soon as it is deemed uncollectible to ensure that financial statements accurately reflect the company's financial position.
This prompt recognition helps provide a true picture of revenue and expenses, maintaining the integrity of financial reporting.
Recognizing bad debt impacts both the income statement and the balance sheet, as it involves recording a bad debt expense and adjusting the accounts receivable.
For instance, unrecognized bad debt inflates accounts receivable, giving a false impression of potential cash inflows.
There are two primary methods to account for bad debt: the direct write-off method and the allowance method. Each method has its advantages and implications for financial reporting.
The direct write-off method involves writing off bad debt directly against accounts receivable when it is determined to be uncollectible. This method is straightforward and typically used by smaller businesses or those using cash basis accounting.
Example Journal Entries:
In this example, the business writes off $500 as bad debt, directly reducing accounts receivable.
However, this method can lead to mismatches in revenue and expense reporting, as the bad debt expense might be recorded in a different period from the related revenue.
This mismatch can distort the financial statements, making it harder to assess the company's true financial performance.
Pros:
- Simple and easy to implement.
- Suitable for businesses with minimal bad debt.
Cons:
- Can result in mismatched revenue and expense periods.
- Not compliant with generally accepted accounting principles (GAAP) for larger businesses.
The direct write-off method is simple and clear, but its simplicity can be a drawback. By only recognizing bad debt when it becomes evident that collection is impossible, this method can distort the financial statements.
Revenues and corresponding expenses may be recorded in different periods, violating the matching principle of accounting. This is why larger businesses or those required to comply with GAAP typically do not use this method.
Related Read: Accounting Essentials: A Detailed Guide to Write-Offs
The allowance method estimates bad debt expense at the end of each accounting period, creating an allowance for doubtful accounts. This contra-asset account offsets accounts receivable, providing a more accurate picture of expected collections.
The percentage of sales method estimates bad debt based on a fixed percentage of the company's total credit sales.
For example, if historical data shows that 2% of sales typically go uncollected, a company with $1,000,000 in credit sales would estimate $20,000 in bad debt.
Example Journal Entry for Estimation
If the following accounting period results in net sales of $80,000, an additional $1,600 is reported in the allowance for doubtful accounts, and $1,600 is recorded in the second period in bad debt expense.
The aggregate balance in the allowance for doubtful accounts after these two periods is $21,600.
The accounts receivable aging method groups all outstanding accounts receivable by age, and specific percentages are applied to each group. The aggregate of all groups' results is the estimated uncollectible amount.
This method determines the expected losses to delinquent and bad debt by using a company's historical data and data from the industry as a whole.
The specific percentage typically increases as the age of the receivable increases to reflect rising default risk and decreasing collectibility.
Example Journal Entry for Estimation:
Let's say a company has $70,000 of accounts receivable less than 30 days outstanding and $30,000 of accounts receivable more than 30 days outstanding.
Based on previous experience, 1% of AR less than 30 days old will not be collectible, and 4% of AR at least 30 days old will be uncollectible.
This is calculated as: ($70,000 x 1%) + ($30,000 x 4%) = $1,900.
If the next accounting period results in an estimated allowance of $2,500 based on outstanding accounts receivable, only $600 ($2,500 - $1,900) will be the bad debt expense in the second period.
The allowance method aligns bad debt expenses with the revenue they help generate, adhering to the matching principle of accrual accounting.
Pros:
- Provides a more accurate reflection of expected losses.
- Complies with GAAP and matches expenses with related revenue.
Cons:
- Requires estimates, which can introduce subjectivity.
- More complex and requires regular review and adjustment.
Let’s explore how bad debt impacts the income statement, balance sheet, and overall financial health of a business.
When bad debt is recognized, it is recorded as an expense on the income statement.
This expense is categorized under selling, general, and administrative (SG&A) costs.
Recording bad debt as an expense reduces the net income for the period, providing a more accurate reflection of the company’s profitability.
Example: If a company recognizes $10,000 in bad debt expense, this amount is subtracted from its total revenues to determine its net income.
This reduction in net income highlights the cost of uncollectible receivables and emphasizes the importance of effective credit management practices.
On the balance sheet, bad debt affects accounts receivable. Specifically, the value of accounts receivable is reduced by the allowance for doubtful accounts, a contra-asset account.
This adjustment provides a more accurate view of the expected realizable value of receivables.
Example: Suppose a company has $200,000 in accounts receivable and estimates $15,000 in doubtful accounts. The balance sheet presentation would be:
By reducing the accounts receivable by the allowance for doubtful accounts, the balance sheet more accurately reflects the amount the company expects to collect.
While bad debt directly impacts the income statement and balance sheet, it also indirectly affects the cash flow statement.
Uncollectible receivables represent potential cash inflows that will not materialize, potentially leading to cash flow shortages.
This can impact a company’s ability to meet its short-term obligations and invest in growth opportunities.
Here are some practical techniques for managing and reducing bad debt:
Conduct thorough credit assessments before extending credit to new customers.
This includes reviewing credit reports, financial statements, and payment histories. Using credit scoring models can help in assessing the creditworthiness of potential customers.
Set appropriate credit limits based on the customer's financial health and payment history. Regularly review and adjust these limits as needed to reflect changes in the customer's financial situation.
Clearly define payment terms and ensure that customers are aware of them. Offer incentives for early payments and establish penalties for late payments to encourage timely settlements.
Recommended Reading: How to Implement Effective Accounts Receivables Policies: A Step-by-Step Guide
Generate and review accounts receivable aging reports regularly to identify overdue accounts. These reports categorize receivables based on the length of time they have been outstanding, helping to prioritize collection efforts.
Maintain regular communication with customers regarding their account status. Sending personalized dunning reminders and follow-up notices for overdue payments can help in accelerating collections.
Conduct periodic reviews of customers' creditworthiness. This is especially important for long-term customers whose financial situation may have changed over time.
Using AR automation software for invoicing and collections can streamline the entire process, making it more efficient and less prone to errors. These platforms send automatic reminders, track payment statuses, and reduce the manual effort involved.
This is where Constant can make a significant impact. Constant is a unified financial automation product designed to optimize productivity, reduce costs, and drive sustainable growth by automating every aspect of finance operations.
With Constant, businesses can handle mundane and repetitive AR tasks seamlessly, regardless of the tools they currently use for their financial operations.
Constant’s features include AI-driven accounts receivable automation and integrations with various accounting and billing platforms, which empower businesses to manage cash flow more effectively.
With real-time data analysis, businesses can make informed decisions faster, achieve quicker payment cycles, reduce days sales outstanding (DSO), and improve cash flow forecasting accuracy.
By automating the entire receivables process, Constant ensures that payments are collected faster and more reliably, accelerating cash flow.
Strengthen internal controls related to credit management and collections. This includes segregation of duties, approval processes for extending credit, and regular audits of accounts receivable.
Train staff involved in credit management and collections on best practices and effective communication techniques. Well-trained staff can handle collections more efficiently and maintain positive customer relationships.
Leverage data analytics to identify trends and patterns in bad debt. Analyzing data can help in understanding the root causes of bad debt and developing targeted strategies to address them.
Consider purchasing credit insurance to protect against significant losses from bad debt. Credit insurance covers a portion of the outstanding receivables if a customer defaults, providing a safety net for the business.
Credit insurance can also help in mitigating risks when extending credit to new or high-risk customers. Insurers often provide credit assessments and monitoring services as part of the policy.
Managing and accounting for bad debt is vital for maintaining a business's financial health. Recognizing bad debt promptly ensures accurate financial reporting and helps businesses implement strategies to mitigate risks.
- Use either the direct write-off or allowance method to account for bad debt, with the latter offering more accurate financial reporting and GAAP compliance.
- Bad debt reduces net income on the income statement and affects accounts receivable on the balance sheet, indirectly impacting cash flow.
- Implement robust credit policies, regular monitoring, and efficient collection practices to minimize bad debt. Consider credit insurance and legal actions for significant debts.
- Strengthen internal controls, train staff, and use data analytics to manage bad debt proactively.
Adopting these practices can enable businesses to minimize the impact of bad debt, improve cash flow, and maintain a healthier financial position.
Proactive management and continuous improvement in credit policies are essential for sustaining financial stability and success.
