Did you know that the average amount of bad debt amongst UK SMEs has risen by a staggering 61% in the last year? Businesses are now writing off an average of £16,641 as unrecoverable yearly.
When you add to that the £68,413 owed, per business, in unpaid invoices and the rising crisis caused by late payments, it's no wonder that companies are looking for ways to reduce their bad debt.
We've put together this guide to help out and give business owners solutions to bad debt other than writing it off as a loss. This article covers how to calculate your bad debt expense formula, examples of its use, what it means, and how you can use it to protect your business.
Bad debt is money that is owed to you that you are unlikely to receive. This could be due to a customer going bankrupt, unwilling or unable to pay, or simply ignoring your invoice requests.
Most businesses react to bad debt by simply writing it off as a loss, worried that chasing the debt may result in a ruined customer relationship or the accrual of more debt as resources are spent chasing unretrievable money.
However, this is not sustainable, and over time, bad debt can have severe implications for a business's financial health. If, as the statistics suggest, most enterprises are already chasing £68,413 in unpaid invoices, writing off an additional £16,641 every year is more than enough to push many companies into financial difficulty.
Why is bad debt so important to track?
Bad debt represents a genuine material threat to the liquidity of your business. With late payments on the rise and customers increasingly unable to pay, it is essential that companies are able to accurately calculate their bad debt expense formula in order to protect their business from the financial implications of this growing crisis.
How much bad debt you are accruing and how you are dealing with it is also a good indication of how effective your accounts receivable process is. If you constantly have to write off bad debt, reviewing your policies and procedures for managing customer payments may be required.
The first step in resolving any bad debt issues is to understand how much you are owed, which is where your bad debt expense formula comes in.
You can use two methods to calculate your bad debt: the direct write-off method and the allowance for doubtful accounts method.
The direct write-off method is the simplest way to calculate bad debt. It simply involves writing off any bad debts as a loss when you become aware that they are likely to be unrecoverable.
Once that occurs, you list a bad debt expense transaction on your Profit and Loss statement, which reduces your net profits.
The direct write-off method is the simplest way to calculate bad debt, as it involves nothing more than listing a transaction on your Profit and Loss statement. It also offers an accurate representation of bad debt in the period that it occurred.
Using the allowance for doubtful accounts method
The allowance for doubtful accounts method is a more sophisticated way of estimating how much bad debt you might incur. It involves creating an 'allowance' account in your balance sheet and making provisions against it based on historical information about bad debt.
Using past payment data, you assess the likelihood of a customer paying and create an estimate of your losses in advance. You can then adjust this amount as new information becomes available.
You then create a 'pool' of funds to cover any losses that might occur and make provisions against them. When a customer does not pay, the amount is deducted from this pool.
The advantage of using the allowance for doubtful accounts method is that you don't have to wait until a debt has been written off as a loss before making provisions for it. This helps you plan ahead and anticipate potential losses rather than dealing with them as and when they occur.
To use the allowance method and take advantage of its benefits, you will need to estimate the amount of bad debt you are likely to incur. The most common way of doing this is by calculating the bad debt expense formula.
You can use two possible formulas for this calculation: the percentage of sales formula or the ageing of accounts receivable formula.
The percentage of sales formula involves taking your current bad debt expenses and dividing it by your total net sales, from which you get a ratio that can be used to estimate future bad debt losses.
The actual formula you would use looks like this:
Bad Debt Expense Formula = Sales for Accounting Period * Estimated % of Bad Debts
The other option for calculating a bad debt expense formula is the ageing of accounts receivable formula. This involves taking the total amount of outstanding invoices and dividing it by your average monthly sales, from which you can calculate an estimated bad debt expense.
The actual formula looks like this:
Bad Debt Expense Formula = Outstanding Invoices / Average Monthly Sales * Estimated % Bad Debts
To clarify exactly how to use the two methods to calculate your bad debt expense formula listed above, let's look at some examples:
In this example, Company A has a total net sales of £100,000 and bad debt expenses of £2,000 for the accounting period.
In this case, the bad debt expense formula would be:
Bad Debt Expense Formula = Sales for Accounting Period * Estimated % of Bad Debts
= £100,000 * 0.02
= £2,000
In this example, Company B has an average monthly sales of £10,000 and outstanding invoices of £2,500.
In this case, the bad debt expense formula would be:
Bad Debt Expense Formula = Outstanding Invoices / Average Monthly Sales * Estimated % Bad Debts
= £2,500 / £10,000 * 0.25
= £625
By working out your company's bad debt expense formula, you can better understand how much bad debt you are likely to incur and plan for it accordingly.
This advanced planning will help you ensure that your business remains financially healthy and is able to withstand any unexpected losses caused by late or unpaid invoices.
Now that we've shown you how to calculate your bad debt expense formula, let's look at some solutions for resolving that bad debt as part of your accounting process, using either the direct write-off method or the allowance for doubtful accounts method.
Using the direct write-off method for Company B's £625 of bad debt, you would simply list a bad debt expense transaction on your Profit and Loss statement. This reduces your net profits by £625.
However, this still impacts Company B's liquidity by keeping cash that should have been collected tied up in bad debt.
Using the allowance for doubtful accounts method, Company A would set aside a portion of their revenue each month to cover the estimated £2,000 of bad debt. This means that they will still be able to keep their cash flow steady and not be affected by the losses.
Additionally, they can adjust their estimated bad debt expenses as new information becomes available. This allows them to have a more accurate representation of their expected losses and make sure that their balance sheet is always up-to-date and accurate.
Bad debt is a certainty of doing business, but if managed correctly it does not have to be a major issue. By calculating your bad debt expense formula and taking steps to reduce the amount of bad debt you accrue, you can protect your business from its financial implications.
Using an approach that combines credit checking, good accounts receivable procedures, a solid credit control policy, and automated payment reminders can help you minimise bad debt and retain more of your business's profits.
To find out more about how Chaser can help you with all of the above in one easy-to-implement package, contact us today for a demo or start your 14-day no obligation free trial!