Bad debt is the term used for any loans or outstanding balances that a business deems uncollectible. This can happen for a variety of reasons, including non-payment by the borrower, fraud, or bankruptcy.
In this guide, we discuss what bad debt is, its impact, what are your options in the case of bad debt occurring, and how to avoid it.
Why do Bad Debts Happen?
There are a number of reasons why bad debts may occur.
1. One of the most common reasons is simply that the customer is unable to pay. This can be due to financial difficulty, job loss, or unexpected expenses.
2. Additionally, some customers may simply refuse to pay their debts, even if they have the ability to do so.
3. In other cases, bad debts may occur because the customer has moved without leaving a forwarding address. This can make it difficult to collect the debt.
4. Finally, some customers may stop responding to attempts to collect the debt. This can make it difficult to determine whether or not they are able to pay.
Impact of Bad Debt on Financial Statements
Bad debt can have a significant impact on your business’s financial statements.
1. When you write off bad debt, it will reduce the value of your accounts receivable. This, in turn, will reduce the amount of cash that your business has on hand. Additionally, it will reduce your business’s equity.
2. Bad debt can also have an impact on your business’s taxes. In most cases, businesses are required to pay taxes on the amount of bad debt that they write off. This can increase your business’s tax liability and make it more difficult to pay other bills or make necessary purchases.
3. Finally, bad debt can also have an impact on your business’s credit rating. This means that if you have a lot of bad debt, it can make it more difficult to obtain financing in the future.
Writing Off Bad Debt
If you are unsuccessful in collecting the debt from the borrower, you may have to write it off as a loss. This means that you will no longer attempt to collect the debt and will instead treat it as if it was never owed to you in the first place.
Bad Debt Provision
When a business is unable to collect payment from a customer, they may choose to make a bad debt provision. This is an accounting measure that allows businesses to write off the value of unpaid debts as a business expense.
This can be beneficial for businesses because it reduces their taxable income and makes it easier to manage their finances.
If you’re considering making a bad debt provision, it’s important to speak with your accountant or financial advisor first. They can help you understand the potential consequences and help you make the best decision for your business.
Estimating Bad Debt
When businesses make a bad debt provision, they are required to estimate the amount of debt that they believe is uncollectible. This can be difficult to do accurately, so businesses often use a percentage of their total receivables.
For example, if a business has £100,000 in receivables and believes that 10% of those receivables are uncollectible, they would make a bad debt provision for £10,000.
There are a few methods that businesses can use to estimate their bad debt.
1. The most common method is to use historical data. This involves looking at the percentage of past receivables that were not collected and using that same percentage to estimate the amount of bad debt for the current year.
2. Another method is to use industry averages. This involves looking at the bad debt percentage for businesses in your industry and using that same percentage to estimate your own bad debt.
3. Finally, some businesses choose to use a combination of historical data and industry averages. This can help you to get a more accurate estimate of your bad debt.
No matter which method you use to estimate your bad debt, it’s important to remember that these estimates are just that: estimates. There is no guarantee that your actual bad debt will match your estimate. This is why it’s important to have a plan in place for dealing with any unanticipated bad debt.
How to Avoid Bad Debt
1. The best way to avoid bad debt is to carefully screen your customers before extending credit. This includes conducting a credit check and requiring a deposit.
2. It’s also important to have clear terms and conditions for your credit policy. This will help to ensure that your customers understand their obligations and know what to expect if they don’t make their payments on time.
3. Additionally, it’s important to stay up-to-date on your customer’s financial situation. This can help you to identify any potential problems early on and take steps to avoid them.
4. Finally, it’s important to have a plan in place for dealing with customers who don’t make their payments on time. This should include a late payment fee and clear terms for collections.
By taking these steps, you can help to reduce the amount of bad debt that your business incurs.
To learn more, get in touch with us today.
