How to avoid bad debt in business

Updated on 6 May 2024

Despite its almost universally negative image, there is more than meets the eye when it comes to debt. In fact, there are two kinds: good debt and bad debt. While the former is often welcomed as a potential source of future value, the latter is to be avoided like the plague. So, what does it take to ensure your business stays in good debt and steers clear of bad debt?    

If companies have the ambition to grow, they usually need to go into debt. Without borrowing and lending, businesses are severely limited in their capacity to expand and develop. Going “into debt” can in fact have a net positive outcome since it offers companies a temporary source of cash that can enable them to invest in – for example – materials, people and real estate.

These investments enable them to win and fulfil new contracts or reduce long-term costs, ultimately boosting business. Good debt usually takes the form of a bank loan. And while the borrower may be temporarily indebted, once the term of payments is over, they will have increased their overall income.

Bad debt is quite a different matter, and it’s what most people think of when they hear the term “debt.” When a customer has trouble paying what they owe to your business for example, it can be tempting to consider it an isolated incident. However, to do so is dangerous and can lead to the more serious problem of bad debt. Bad debt occurs when a business can no longer collect payments that customers owe. This is usually the beginning of a situation that can have far-reaching consequences.

Because debt freezes up a business’s cash flow, this blocks its capacity for growth. Less money coming in limits a company’s ability to pay its own loans and clients. This domino effect continues, and the company can find itself in the uncomfortable position of becoming a debtor itself. If several clients fail to pay their debts, or if a single large client defaults on payment, a business can very quickly find itself facing insolvency and closure.

Business looking to protect themselves from bad debt have a number of options. The simplest is to research potential clients thoroughly before selling goods or products to them. This puts you in a strong position by making sure you do not even do business with clients that seem unlikely to pay.

Another option is to enlist the counsel and advice of a credit insurer. If a client is late with payments on an invoice, they can simply report it to their insurance provider, and their teams will take care of ensuring payment is collected. This service helps prevent the build-up of bad debt and its domino effects.

In the current global context, we at Allianz Trade in Canada are seeing companies come to us for advice on how to avoid bad debt. We support companies by streamlining collections and providing extensive advice on the liability risk of potential customers.