Published on 7 May 2024
Cash flow is the lifeblood of any business. Anything that reduces cash flow can jeopardize the success or even the survival of a business. Extending credit to customers can be an astute business move, but also opens the possibility of slower or reduced cash flow, due to the late payment of invoices. In some unfortunate cases, the credit may turn into a bad debt. Although some level of bad debt is often unavoidable, steps can be taken to minimize it.
This article contains
Key takeaways
- Bad debt represents money due to your company which is unlikely to be paid
- Tracking and managing bad debt is essential to ensure it does not threaten your company’s financial health
- There are two methods of calculating bad debt: the direct write-off method and the allowance method
- Companies can take measures to limit the risk of bad debt
What is bad debt expense?
Simply put, a bad debt expense is money that is owed to your business that you are unlikely to receive. A customer may default on their bill due to bankruptcy, insolvency, or other financial problems, or may refuse to pay because they are dissatisfied with the goods or services they have received.
Whenever a company extends loans to clients in the form of credit, it faces the possibility of a bad debt expense.
In most cases, the benefits of extending credit outweigh the risks of a bad debt expense, but it is in your best interests to track and manage bad debts to make sure they do not become a more serious threat to your company’s financial health.
Bad debt expenses must be charged against the company's accounts receivable, reducing the amount of accounts receivable on the company’s income statement.
Is bad debt an expense?
A bad debt is typically considered to be an expense, usually classified as sales and general administrative expenses. Bad debt expenses are recorded on the company’s income statement and offset the accounts receivable.
How to calculate a bad debt expense
To calculate bad debt expense, the total amount of all accounts receivable is divided by the total amount of the bad debt and then multiplied by 100.
There are two ways to calculate bad debt expenses: the direct “write-off” method and the “allowance” method. The write-off method writes off uncollectable debts directly as expenses, as and when they arise. The allowance method calculates an estimate of bad debt which is continually tracked and revised.
For example, a company with €1 million in accounts receivable and $50,000 in bad debt would calculate the bad debt expense with the following formula:
$1,000,000 / $50,000 = 0,5
To turn this into a percentage, it is multiplied by 100:
0.5 x 100 = 5%
In other words, the company's bad debt expense represent 5% of its account receivable.
The direct write-off method
The direct write-off method reports the exact amount of bad debt on an organization’s income statement when the non-paying customer's account is written off. This may sometimes be weeks or even months after the transaction took place.
Using the write-off method, an entry debiting the bad debts expense and crediting the accounts receivable is created.
The main disadvantage of using the write-off method is that there is a mismatch between the time when the transaction took place and the time when the amount was written off. This may mean discrepancies between reporting periods.
The allowance method
The allowance method, or the “allowance for doubtful accounts” method to be more precise, overcomes the discrepancies posed by the write-off method by estimating anticipated losses at the end of each reporting period. Accountants review the accounts receivable and estimate the amount that the company will not be able to collect.
The expense is then recorded according to the “matching principle,” in the same period as the transaction occurred.
That estimated amount is credited to accounts receivable. This allows the bad debts expense to be recorded closer to the actual transaction time and results in the company’s balance sheet reporting a more realistic net amount of accounts receivable.
The impact of bad debts on business
Bad debts are not good for a business. While one or two bad debts of small amounts may not make much of an impact, large debts or several unpaid accounts may lead to significant losses and may even result in bankruptcy. Bad debts also make your company’s accounting processes more complicated and, in addition to monetary losses, take up valuable staff time and resources as they try to collect on the debt.
Protection against bad debt
While companies are unlikely to be able to avoid bad debt expenses entirely, they can protect themselves from bad debt in several ways. The allowance for doubtful accounts method helps companies estimate the amount of bad debt, helping them anticipate difficulties.
Another way is for companies to set limits when extending customer credit to minimize their exposure to bad debt. Such limits can be set to manage existing and potential bad debt expenses overall and for specific customers. For example, a company could dictate tighter credit terms based on each customer’s unique circumstances.
If a customer has a poor credit record, a company might minimise the risk of bad debt by requiring them to procure a letter of credit to guarantee payment or by requiring prepayment before shipment.
In some cases, companies may also want to change the requirements for extending credit to customers. For example, if customers in a certain
industry and geographic area are struggling, companies can require these customers to meet stricter requirements by extending credit. The same strategy could be used to manage credit for customers with outstanding debts over a certain amount or who are a certain number of days late on their bills.
What is bad debt protection?
Bad debt protection solutions can help limit losses when customers are unable to pay their bills.
There are many different solutions that companies can seek to protect themselves against bad debt. Two of the main approaches are trade credit insurance and non-recourse factoring.
Trade credit insurance
Trade credit insurance provides insurance against customer non-payment in a wide range of circumstances.
The best trade credit insurance solutions also provide credit data and intelligence designed to help companies improve their credit-related decision-making and credit management. The goal is to prevent losses from bad debt. Since bad debt can never be entirely avoided, trade credit insurance policies are established to cover any losses that occur even after steps have been taken to minimize losses, such as thorough credit controls.
Trade credit insurance provides coverage for a wide range of bad debt-related losses, while also providing businesses with the tools and support to manage their credit and accounts receivable more effectively.
Allianz Trade provides customzied trade credit insurance solutions to help businesses avoid bad debts and safely expand credit and sales to new and existing customers.
Non-recourse factoring
Non-recourse factoring takes place when a company sells its invoices to a “factor,” receiving a percentage of their value. The factor then takes on the task of chasing the unpaid invoice. When payment is fully recovered, the balance is paid to the original company, in exchange for a fee.
Should the factor fail to collect the debt, the factor absorbs this cost, in contrast to “recourse factoring,” where the cost would fall to the original company.
Conclusion
Allianz Trade provides customized trade credit insurance and other expert solutions to ease the stress associated with extending credit. Our mission is to help customers around the world avoid risk, trade wisely and develop their businesses safely.
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