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Jul 1, 2024

How to Manage Bad Debt Expense in Your Business

Divyesh Gamit



Running a business is exciting, but sometimes invoices go unpaid. It happens to the best of us. Maybe a customer loved your product but hit a financial snag. Whatever the reason, those unpaid invoices become bad debt expenses.

Think of it like this: you make a sale, but instead of getting that cash right away, you're left waiting. Weeks turn into months, and it sinks in - that money might never come. That missing amount is bad debt, the cash you were counting on that just disappears.

Here's the kicker: bad debt expense is a reality for most businesses. Customers face financial problems sometimes, and bills go unpaid. That's why it's super important to account for bad debt.

Why? Because your financial statements are a report card for your business's health. Factoring in bad debt expense keeps that report card accurate. It shows realistic numbers on your income and what customers owe you. This way, you can make smart decisions based on real finances, not just hoping everyone pays up!

So, keep reading! We'll explore how businesses calculate bad debt expense and share some tips to keep it under control. Let's turn those ouch moments into smooth sailing for your business finances!

Methods for Calculating Bad Debt Expenses

Alright, so you know bad debt exists and can impact your business. Now, let's get down to the nitty-gritty: how do you calculate it? Here are two popular methods:

A. The Percentage of Sales Method: Easy Does It

Imagine your total sales are like a pie chart. A small slice of that pie represents sales you might never collect on. This method estimates that slice as a percentage of your total sales.

  • How it works: Take your bad debt from past years and divide it by your total past sales. This gives you a percentage. Apply that percentage to your current sales to estimate your bad debt expense.
  • The good: Super easy to understand and use, especially for smaller businesses. No complex calculations needed!
  • The not-so-good: Doesn't take into account changes in your customer base or credit policies. Maybe you tightened up who gets credit lately? This method wouldn't reflect that.

B. The Aging of Accounts Receivable Method: A Deeper Look

This method takes a closer look at your unpaid invoices, grouping them by how long they've been outstanding. The older an invoice, the less likely you are to collect on it, generally speaking.

  • How it works: Break down your unpaid invoices by how long they've been waiting for payment (for example, 30-60 days, 60-90 days). Based on past experience and what's typical in your industry, estimate the percentage of uncollectible invoices in each category. Multiply those percentages by the total amount owed in each category to estimate your bad debt expense.
  • The good: Provides a more accurate picture of bad debt risk based on how old the invoices are. That makes sense, right? The longer someone waits to pay, the less likely they are to catch up.
  • The not-so-good: Requires more data and analysis compared to the percentage of sales method. There's a little more legwork involved here.

Remember, there's no one-size-fits-all method. Choose the one that best suits your business size and how complex your finances are.

Also Read: The Magic of Intelligent Data Extraction for Streamlined Business Processes

Types Of Bad Debt

Bad debt can come in different flavors, depending on who owes the money. Here's a quick breakdown of two main types:

  • Consumer Bad Debt: This is the kind we've been talking about most so far. It happens when individual customers don't pay for credit purchases, like credit cards or personal loans.
  • Commercial Bad Debt: This occurs when businesses owe money to other businesses but can't repay it. Maybe a supplier isn't paid for delivered goods, or a company defaults on a loan.

Understanding these types can help you tailor your approach to managing bad debt. For example, you might have stricter credit policies for larger business transactions compared to individual customer purchases.

Best Practices for Managing Bad Debt Expenses

So, you've got the tools to calculate bad debt expenses. Now let's explore some battle tactics to keep that expense under control! Here are five top tips:

Tip 1: Set Clear Credit Ground Rules

Imagine a game of tag – everyone needs to know the rules, right? A clear credit policy is like your business's tag rules. It outlines who gets credit, how much, and what happens if payments are late. This keeps things fair and helps avoid bad debt from customers who might not be a good credit risk.

Tip 2: Choose Your Players Wisely

Not everyone gets to play tag! Before extending credit, screen your customers carefully. Check their credit history and make sure they're financially healthy. This helps you choose reliable "players" who are more likely to pay on time.

Tip 3: Keep an Eye on Your Outstanding Invoices

Think of your accounts receivable as a treasure chest – money owed to you! Regularly monitor those invoices to make sure they don't get buried and forgotten. This helps you catch potential problems early and take action before invoices become too old to collect.

Also Read: Import Data from PDF to Tally In Easy Steps

Tip 4: Be Prompt, But Polite, About Collecting

Sometimes, people forget or life gets hectic. When invoices are overdue, send friendly reminders. A quick email or phone call can jog their memory and get things back on track. Be professional and courteous, but firm about collecting what's owed.

Tip 5: Don't Cling to Uncollectible Debts

Letting go can be tough, but sometimes you get to cut your losses. If a debt is truly uncollectible, write it off promptly. This keeps your books clean and allows you to focus on collecting from reliable customers. Remember, managing bad debt expenses is an ongoing process. By following these tips, you can keep that beast under control and ensure your business finances stay healthy!

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