The Risks of Using Bad Debt Reserves

What Is A Bad Debt Reserve (Allowance for Doubtful Accounts)?

A bad debt reserve, also known as an allowance for doubtful accounts (ADA), is when a company ties up large sources of capital to protect themselves from loss. It’s the total amount of receivables the company never expects to collect.

With trade credit insurance, a different form of protection against loss, companies can deploy their capital where it’s needed most—to support their growth and innovation.

When deciding how to best protect your business from loss and non-payment, it’s very important to consider your options before making a decision.

Are Allowances for Bad Debts a Good Idea?

One common area where companies fail to evolve is in continuing to own their own risk when it comes to insuring their accounts receivable. In these instances, business owners agree to accept the loss of any unpaid invoice amounts, plus the full costs required to manage their internal credit grading processes. These businesses use a bad debt reserve to offset losses, research customers of their own and own all the risk internally.

Self-insuring by using bad debt reserves may come without a direct cost, but it offers limited benefits in the event of a catastrophic loss. Remember, unpaid invoices weaken your cash flow and those additional costs will add up quickly. Utilizing an allowance for doubtful accounts if a customer doesn’t pay also requires more internal resources to manage the risk. Use the comparison chart below to see how much you might be costing your business.

Trade Credit Insurance (TCI): A Better Alternative to Bad Debt Reserves

Trade credit insurance protects your business from non-payment of commercial debt, making sure invoices are paid, and allowing you to reliably manage the commercial and political risks of trade beyond your control. It protects your capital, maintains your cash flows, and—most importantly—secures your earnings against defaults. When compared to self-insurance, TCI provides you with a safer, more strategic accounts receivable management option. To break it down further, take a look at how both approaches compare for various aspects of your business.

A Comparison of Methods: Bad Debt Reserves vs. Trade Credit Insurance

Feature Self-Insurance Through Allowance
for Doubtful Accounts
Credit Insurance
Coverage Any loss. You can recover one
dollar for every dollar you reserve
Insolvency, protracted default, and political risks. Maximum liability at +/- 50x
premium so your dollar goes 50 times farther
Services Internal resources Credit information, risk assessment, market intelligence, debt collection
Financing None, but often required
by financing sources
Typically allows foreign receivables and other exclusions to be added
back into your borrowing base
Customer
Relationship
Maintain a direct relationship
with the customer
Buyer is unaware of the credit insurance contract; better terms enhance the
relationship with the customer

Find a Solution with Euler Hermes

How many opportunities are you missing by self-insuring your business with an allowance for doubtful accounts? Now that you’re working with some raw numbers, can you imagine what you could do with this working capital? With soft costs affecting your bottom line, could you realize increased efficiencies by allowing trade credit insurance to handle the risk while you put that money to work?

Euler Hermes can help companies that rely on bad debt reserves transition to the safer option, trade credit insurance. We have solutions available for any business at any size. Partnering with us allows you to offer your customers faster credit limit extensions with access to ongoing monitoring of your customers, and more.

Click here to contact us for more information on investing your business and future with trade credit insurance.