What is Bad Debt?
Bad debt occurs when a customer is unable or unwilling to pay for goods or services provided, and the amount is considered uncollectable. After all reasonable efforts to recover the debt have been made, it’s written off as a loss.
Bad debt directly impacts your business’s bottom line and reflects a loss in expected income, reducing the overall profitability.
How to Calculate Bad Debt
There are two common approaches to calculating bad debt:
1. Direct Write-off Method
In this method, the debt is written off as soon as it is confirmed that the payment will not be made. This method is straightforward but doesn’t always give an accurate picture of financial health, as it doesn’t align with the timing of the sale.
Example:
If a business sells goods worth $10,000 and the customer cannot pay, the business writes off the $10,000 when it becomes clear that payment won’t be received.
2. Allowance Method
This method involves estimating a percentage of receivables that might not be collected based on past experience. It gives a more realistic view of potential losses by accounting for bad debt ahead of time.
Example:
If a company expects 3% of its $50,000 receivables to be uncollectable, it would set aside $1,500 in a provision for doubtful accounts.
Why Bad Debt Matters
Effectively managing bad debt is critical for maintaining healthy cash flow and ensuring the financial stability of your business. High levels of unpaid debt can disrupt your ability to cover expenses and meet obligations.
It’s also a sign of how well your credit policies are working. If you consistently face bad debts, it might be time to review your payment terms or improve your customer vetting process.
How to Minimise Bad Debt
To reduce the risk of bad debts, consider these practical steps:
- Run Credit Checks: Before extending credit, assess the creditworthiness of new clients.
- Send Invoices Promptly: Timely billing helps encourage prompt payments. Follow up regularly on overdue amounts.
- Set Clear Payment Terms: Offer incentives for early payments or introduce stricter payment terms where necessary.
- Consider Debt Collection Services: For persistent non-payers, engaging a debt collection service can help recover unpaid debts.
Need Help with Managing Bad Debt?
At First Class Accounts, we provide bookkeeping services that help businesses stay on top of receivables and minimise exposure to bad debt. Whether you need advice on managing credit policies or help with collections, our team can support you in safeguarding your business’s financial health.Looking for a qualified bookkeeper to support your business? Contact us today to find a local First Class Accounts bookkeeper who can help you take control of your finances and ensure your business stays on track.