Cash flow is the lifeblood of any business so anything that reduces cash flow could jeopardize business success or even its survival. Any company that extends credit to its customers is at risk of slower or reduced cash flow if any of that credit turns into bad debt expense. Although some level of bad debt expense is often unavoidable, there are steps companies can take to minimize bad debt expense.
What is Bad Debt Expense?
When a customer defaults on its bills or is in danger of doing so, the company extending credit to that customer faces a bad debt expense. Bad debt expense reflects the amount of accounts receivable that a company is unable to collect now and may not be able to collect in the future. Because this bad debt expense must be charged against the company's accounts receivable, bad debt expense reduces the amount of accounts receivable on the company’s income statement.
There are many examples of companies dealing with bad debt expense. One company changed its approach to bad debt management after two major clients defaulted on their bills, leaving the company facing tens of thousands of dollars in losses. To make matters worse, the company had also dedicated considerable staff time and resources trying to collect on those bad debts with no success. By purchasing credit insurance, the company not only protected itself against future losses from bad debt, but it also was able to leverage that protection as it pursued growth with new customers.
Another company that was growing rapidly grew concerned about its exposure to potential bad debt expense as its customer base expanded. In the past, the company knew all of its customers either personally or by reputation. However, as it grew, the company recognized that it could not eliminate the risk of bad debt expense entirely. It had so many new customers coming on board that it had to evaluate their creditworthiness via third party data and information that did not always provide an accurate picture of a customer’s financial state. The company ultimately decided to purchase credit insurance to reduce its exposure to bad debt expense. -Johnstone Supply
How Do You Calculate Bad Debt Expense For Accounts Receivable?
Bad debt expense is calculated as a percentage of total accounts receivable. To calculate bad debt expense, divide the total dollar amount of all accounts receivable by the total dollar amount of bad debt then multiply that number by 100. For example, a company with $1 million in accounts receivable and $50,000 in bad debt would calculate bad debt expense using this formula:
$1,000,000 ÷ $50,000 = .05
To turn that into a percentage, multiply this number by 100:
.05 x 100 = 5%
In this case, the company’s bad debt expense represents 5% of its accounts receivable.
One of the best ways to manage bad debt expense is to use this metric to monitor accounts receivable for current and potential bad debt overall and within each customer account. By setting certain thresholds for current and potential bad debt, a company can take action to manage and prevent bad debt expense before it gets out of hand.
Bad Debt Protection
While a company is unlikely to avoid bad debt expense entirely, it can protect itself from bad debt in a number of ways. One way is for companies to set various limits when extending customer credit to minimize bad debt expense. Such limits can be set to manage existing and potential bad debt expense overall and for specific customers. For example, a company could dictate tighter credit terms based on each customer’s unique circumstances. In some cases, a company might avoid extending credit at all by requiring a buyer to procure a letter of credit to guarantee payment or require 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 or geographic area are struggling, companies can require these customers to meet stricter requirements before the company will extend credit. The same strategy could be used to manage credit for customers that have outstanding debts over a certain amount or that are a certain number of days late on their bills.
What is bad debt protection?
Bad debt protection can help limit some losses when customers are unable to pay their bills. However, it does not provide protection against every type of loss.
What is the benefit of bad debt protection?
Companies can obtain bad debt protection that provides payment when a customer is insolvent and is unable to pay its bills.
However, because there are reasons other than insolvency for customer nonpayment, this type of bad debt protection is of limited use for most companies.
What’s the difference between trade credit insurance and bad debt protection?
If bad debt protection does not fit a company’s needs, there are alternatives. The best alternative to bad debt protection is trade credit insurance, which provides coverage for customer nonpayment in a wide range of circumstances.
The best trade credit insurance also provides 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 no company can avoid bad debt entirely, the trade credit insurance policy is in place to cover any losses that occur even after the company and the insurer have taken steps to minimize losses.
While bad debt protection only covers “losses from customer insolvency,” trade credit insurance covers “protracted default,” which is when a solvent company is late with its payment or simply fails to pay at all. A large, specialty trade credit insurance carrier can also tailor a policy to cover many other eventualities, including:
- Unpaid invoices as a result of natural disaster
- Unpaid invoices as a result of political risk; for example, when doing business in other countries
- Losses that occur as a result of problems before goods are shipped; for example, this could involve custom-produced goods that cannot be sold to another customer
- Losses occurring after shipment by a contracted third party
- Losses occurring when selling on consignment terms
Protect Your Business Against Bad Debt Expense with Trade Credit Insurance
Although bad debt expense can be detrimental to a business’s long-term success, there are ways to manage this expense and mitigate bad debt-related risks. 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.