What is ‘bad debt’?
This is simply a term used to describe a situation when money owed is not paid. When a business offers invoice payment terms, also called a ‘credit sale’ it gives the customer a period of time to pay the money owed. If the amount isn’t paid and the business can’t recover the money, it’s called bad debt.
The bad debt rate, also called the bad debt ratio, is a way to measure the proportion of accounts receivable that is no longer collectable. In its simple form the ratio is the amount of products or services sold with payment terms over a given period divided by the amount that won’t be repaid. For example, if your business sells $500,000 in one year on trade credit and $5,000 will not be repaid, the bad debt ratio is 1 per cent ($5,000 ÷ $500,000 = 0.01).
If your business uses accrual accounting, as opposed to cash accounting, this is a bit more complex. With accrual accounting, the sale is considered income when the invoice is raised, not when the money is received (as is the case with cash accounting). So with accrual accounting, the sale immediately appears on the income statement when the invoice is created. Businesses using accrual accounting also need to pay GST and income tax based on these sales, so you will also want to consider the bad debt tax treatment if you are choosing between cash and accrual accounting. With accrual accounting, the bad debt ratio for a period is:
(Accruals for doubtful and old accounts – Recovery for accruals for old and doubtful accounts) ÷ Turnover
Regardless of the accounting method you use, it’s essential to minimise this number. In addition to negatively affecting cash flow bad debt will also impact the balance sheet by decreasing assets when the amount of accounts receivable is lowered.
How to avoid bad debts
Every small business deserves to get paid for the products and services it provides but this doesn’t always happen. Fortunately, there are ways to minimise the amount of commercial bad debts. This starts with having clear credit policies and procedures in place and following them. This begins with having each customer complete a credit application and signing it. It also includes checking credit references and credit history to ensure that the business in question has paid its debts in the past.
If you’re not sure about the ability of a business to pay its invoices, you can start with a small credit limit and increase this amount after they have a proven payment record. Also, if a debtor has outstanding invoices that are overdue, you can stop additional credit purchases until the existing ones have been paid. These processes can be outlined in your credit policies and procedures.
Once an invoice has been issued, it’s important to follow up immediately if it’s not paid by the due date, as the longer an account is overdue, the more likely it will turn into a bad debt. The written procedures should include when you take certain steps, such as calling or emailing about late payments. Learn more in How to Protect Your Business With Credit Policies and Procedures.
How to recover bad debts
If you have debts that haven’t been paid after making phone calls and sending emails, you can try using the services of a debt collection agency. When you hire professional debt collectors, it escalates the issue with the debtor. Debt collection agencies specialise in tactics for recovering bad debts. This can include taking legal action against the debtor as a last resort.
Although hiring a debt collector can remove some of the stress from the situation, it comes at a cost. Debt collection agencies charge a commission based on the amount of the debt recovered. These commissions can range from 5 per cent to 30 per cent of the invoice amount. Usually the commission is higher for the lower invoice amounts, so you might pay 30 per cent to recover a $1,000 debt and 5 per cent for recovering a $25,000 debt. This is because it can take a similar amount of time and effort to collect a small amount as a large one.
A new way to avoid bad debt altogether
If your business sells to other businesses, you probably experience late payments and bad debt. Even if you are effective at avoiding bad debts, you probably still have late-paying customers who negatively impact your cash flow. In addition, chasing outstanding invoices can be stressful and requires time and money.
Moula Pay was created to help businesses overcome the shortcomings of offering invoice payment terms and creates a win-win situation for buyers and sellers.
Moula Pay is a smarter way to offer your business customers payment terms. When your customers pay with Moula Pay, you get paid upfront. Your customers enjoy up to 12 months to pay, with the first 3 months interest and repayment-free.
Become a Merchant today to:
- Get paid upfront: Give your customers great payment terms that improve your cash flow
- Stop chasing payment: Outsource the pain of chasing receivables, and let Moula take the risk of unpaid invoices
- Sell more, more often: Providing your customers with access to more funds means they can spend more with you.
Learn more about how Moula Pay can give your customers great payment terms and eliminate the need to chase overdue invoices.