How to calculate bad debt expense and what to do with the result

Are you facing questions from your board about increasing Days Sales Outstanding (DSO)? Or has your controller brought up concerns regarding accounts receivable (AR) aging trends?

Given the current post-pandemic credit landscape and ongoing inflationary pressures, the accurate assessment and management of bad debt expense are more vital than ever.

This guide will provide you with the key methods for calculating bad debt. More importantly, it will outline the strategic actions you can take, armed with this critical financial insight.

How to calculate bad debt expense

The percentage of sales method is a simple way to estimate how much money you might lose from unpaid debts. You just take a percentage of all the sales you made on credit during a certain time. People often like this method because it's easy to use.

Formula:

Sample calculation with a $50M USD revenue company:

Let's assume a company with $50,000,000 USD in annual revenue, where 80% of sales are on credit. Historically, the company has experienced a 2% bad debt rate on its credit sales.

1. Calculate total credit sales:
   $50,000,000 USD (total revenue) × 0.80 (percentage of credit sales) = $40,000,000 USD (Total credit sales)
   
   
2. Calculate bad debt expense:
   $40,000,000 USD (total credit sales) × 0.02 (bad debt rate) = $800,000 USD (estimated bad debt expense)

Therefore, based on the percentage of sales method, the estimated bad debt expense for this company would be $800,000 USD. This amount would be recorded as an expense on the income statement and an allowance for doubtful accounts on the balance sheet.

2 methods to calculate bad debt expense

When assessing bad debt, companies typically utilize 2 primary methods for calculation: the direct write-off method and the allowance method.

Direct write-off method

The direct write-off method is the simpler of the 2. Under this approach, a company recognizes bad debt expense only when it becomes certain that an accounts receivable is uncollectible. 

At that point, the specific receivable is written off directly against the bad debt expense account. While straightforward, this method can violate the matching principle of accounting, as it doesn't match expenses with the revenues they helped generate in the same period.

The allowance method

The allowance method, considered more accurate and generally accepted under Generally Accepted Accounting Principles (GAAP), estimates bad debt expense before specific accounts become uncollectible. 

This method aims to match the estimated uncollectible accounts with the sales they relate to. It involves creating a contra-asset account called "Allowance for Doubtful Accounts." There are 2 common approaches within the allowance method:

Percentage of bad debt (for projections)

This approach estimates bad debt as a percentage of a company's total credit sales for a given period. It's often used for broad projections and relies on historical data to determine the appropriate percentage.

Accounts receivable aging analysis method (for reserves)

This method analyzes the age of outstanding accounts receivable. The older an account, the higher the probability it will become uncollectible.

Different percentages are applied to different age categories, leading to a more precise estimate of the required allowance for doubtful accounts. This method is particularly useful for establishing specific reserves.

Which bad debt calculation is best for you

Ultimately, the "best" bad debt calculation method depends on your business model, reporting requirements, and the level of accuracy needed for financial planning and decision-making.

Here's a breakdown to help you determine which method suits your needs:

Business model considerations

Different industries and business models have unique characteristics that influence bad debt exposure and the most appropriate calculation method.

Manufacturing companies (Net 60 terms)

Manufacturing companies often extend net 60 payment terms, especially to larger B2B clients. 

A longer duration provides more opportunities for unforeseen circumstances to arise, such as economic downturns, changes in market conditions, or financial difficulties experienced by the paying party.

These factors can negatively impact their ability to meet their financial obligations on time.

• Impact of extended payment terms: With longer payment cycles, the window for accounts to become delinquent widens. This means a greater portion of your accounts receivable will age, potentially leading to higher bad debt if not managed effectively.
  
  
• Bad debt benchmark: For manufacturing, a typical bad debt benchmark ranges from 1-3% of credit sales, depending heavily on the customer mix (e.g., strong, established clients versus newer, higher-risk customers).
  
  
• Factors to consider:
  • Customer credit limits and guarantees: Implementing and rigorously enforcing credit limits for customers is crucial. For large orders or new clients, consider requiring credit guarantees or upfront payments.
    
    
  • Economic cycles: Manufacturing is sensitive to economic downturns, which can directly impact customer solvency and increase bad debt.
    
    
  • Supply chain disruptions: Issues in the supply chain can affect your customers' ability to pay, indirectly contributing to bad debt.
    
    

Services businesses (milestone billing)

Services businesses, particularly those with project-based work, often use milestone billing.

While this can mitigate risk, the lump sums involved at each milestone can still present bad debt challenges.

• Impact of milestone billing: If a client fails to make a milestone payment, the entire preceding work for that milestone can become uncollectible.
  
  
• Bad debt benchmark: Professional services typically see a bad debt rate of 2-4% of billed revenue, depending on the industry and client base (e.g., enterprise vs. small business).
  
  
• Factors to consider:
  • Project scope changes: Uncontrolled scope creep can lead to disputes and payment delays, increasing bad debt risk.
    
    
  • Client communication: Clear communication regarding project progress and upcoming milestones is vital to ensure timely payments.
    
    
  • Contractual agreements: Robust contracts with clear payment terms and clauses for non-payment are essential.
    
    

E-commerce companies (chargeback and return write-offs)

E-commerce businesses face unique bad debt considerations primarily from chargebacks and high return rates, which effectively act as write-offs.

• Impact of chargebacks and returns: Chargebacks can occur due to fraud, customer disputes, or service issues, directly reducing revenue. High return rates can also lead to significant write-offs for goods that cannot be resold.
  
  
• Bad debt benchmark: E-commerce bad debt, often encompassing chargebacks and unrecoverable returns, can range from 0.5-2% of sales, though this can vary significantly based on product type and fraud prevention measures.
  
  
• Factors to consider:
  • Fraud prevention: Investing in robust fraud detection systems is paramount to minimizing chargebacks.
    
    
  • Return policies: Clear and fair return policies can reduce disputes and customer dissatisfaction.
    
    
  • Payment gateway reliability: A reliable payment gateway with strong dispute resolution processes is crucial.
    
    

SaaS companies (monthly vs. annual contracts)

SaaS companies experience bad debt primarily through subscriber churn or non-payment, with the contract structure playing a significant role.

• Impact of contract length: Monthly contracts can lead to higher churn and more frequent instances of non-payment. Annual contracts, while offering more predictable revenue, can result in a larger single bad debt event if a customer defaults.
  
  
• Bad debt benchmark: SaaS companies typically have a bad debt rate of 0.5-1.5% of recurring revenue, lower than other industries due to subscription models and automated payments.
  
  
• Factors to consider:
  • Customer onboarding and engagement: Strong onboarding and ongoing customer success efforts can reduce churn.
    
    
  • Automated payment systems: Relying on automated billing and payment retry mechanisms can minimize non-payment.
    
    
  • Value proposition: Continuously demonstrating value to customers helps retain them and reduces churn.

Recovery rate considerations for suspended accounts

Even after an account is deemed uncollectible and potentially written off, there's often an opportunity for recovery, especially for suspended accounts (e.g., accounts temporarily put on hold due to non-payment).

• Benchmark recovery rates:
  • Credit card accounts: 0.5-2%
  • Invoiced accounts: 2-5%
• Factors influencing recovery: The effectiveness of your collections process, the age of the debt, and the financial health of the debtor all play a role in actual recovery rates.

Decision tree: Which method for which decision, and when

Choosing the right bad debt calculation method is crucial for accurate financial reporting and strategic decision-making.

Analyzing your result: When is bad debt a problem?

Raw bad debt percentages, while important, truly come alive when translated into actionable business insights. They aren't just numbers on a spreadsheet; they are indicators of your credit policy's effectiveness and the underlying health of your customer base.

For instance, a rising percentage might signal a weakening economy impacting your customers or an overly lenient credit approval process.

Industry benchmarks and comparison

Comparing your bad debt percentage to industry benchmarks is crucial. What's "normal" varies significantly by sector. A 2% bad debt rate might be excellent for a manufacturing company, but concerning for a SaaS business. Regularly tracking these comparisons helps you understand if your performance is an anomaly or reflects broader market trends.

When to worry vs. when it's normal

You should start worrying when your bad debt percentage consistently exceeds historical trends, industry benchmarks, or your internal risk tolerance.

Occasional spikes might be normal due to specific large defaults, but a sustained upward trend necessitates a deep dive into your credit management, collections processes, and customer acquisition strategies. 

High bad debt directly erodes your gross margins and profitability. Every dollar of uncollectible revenue is a dollar that doesn't contribute to covering operating expenses or generating profit. It reduces the effective revenue generated from sales, making it harder to hit financial targets.

Conversely, a stable or decreasing percentage, even if not zero, can be a sign of effective credit control and healthy customer relationships.

Best practices for calculating bad debt expense

Calculating bad debt is not just a financial exercise; it's a critical component of risk management and strategic financial health. Here are the best practices to keep in mind: 

Set credit limits that don't affect sales

Establishing appropriate credit limits is a delicate balance. Too restrictive, and you might lose out on valuable sales opportunities; too lenient, and you risk higher bad debt. The goal is to maximize sales while minimizing risk.

• Assess customer creditworthiness: Utilize credit scores, financial statements, and payment history to determine a suitable credit limit for each customer.
  
  
• Tiered approach: Implement different credit limits based on customer segments (e.g., new customers, established customers, high-volume customers).
  
  
• Regular review: Periodically review and adjust credit limits as customer financial health changes or as your risk appetite evolves.

Make use of collection practices that preserve relationships

Collections don't have to be adversarial. Effective collection practices focus on recovering overdue payments while maintaining positive customer relationships, crucial for long-term business success.

• Early and polite reminders: Send automated and personalized reminders before and immediately after an invoice is due.
  
  
• Clear communication: Ensure your invoices are clear, accurate, and contain all necessary payment information.
  
  
• Flexible payment options: Offer various payment methods and consider payment plans for customers facing temporary difficulties.
  
  
• Escalation protocol: Establish a clear, escalating collection process that begins with gentle reminders and only progresses to more assertive actions if necessary.

Set up a bad debt monitoring system

A robust bad debt monitoring system provides ongoing visibility into your accounts receivable health and allows for proactive intervention.

• DSO trending: Track DSO over time. A rising DSO indicates that it's taking longer to collect payments, potentially signaling increasing bad debt risk. Analyze trends to identify root causes and implement corrective actions.
  
  
• Aging bucket movement: Closely monitor the movement of accounts receivable through different aging buckets (e.g., 30, 60, 90+ days overdue). A disproportionate increase in older buckets is a strong indicator of deteriorating collectibility.
  
  
• Recovery rates: Track the actual recovery rates on previously written-off or suspended accounts. This data can inform future bad debt estimations and help optimize collection strategies for past-due accounts.
  
  
• Customer segment performance: Analyze bad debt performance by customer segment (e.g., industry, size, geographic location). This can reveal which segments pose higher risks and allow you to tailor credit policies and collection efforts accordingly.

How Chaser can help prevent bad debt

Chaser offers an intelligent automated invoice chasing solution designed to significantly reduce bad debt. By combining the efficiency of automation with a crucial human touch, Chaser ensures timely and polite reminders are sent to customers, improving payment rates without damaging relationships. 

Its customizable communication allows businesses to maintain a professional and empathetic tone, escalating only when necessary. This proactive approach helps businesses recover overdue payments more effectively and prevent accounts from becoming uncollectible.

Reducing your exposure to bad debt

Calculating and managing bad debt expense is more than just an accounting task; it's a strategic imperative for financial health and sustainable growth.

By understanding the various calculation methods, considering your business model's unique risks, and implementing best practices for credit management and collections, you can significantly reduce your exposure to uncollectible accounts.

To take proactive control of your accounts receivable and minimize bad debt, consider Chaser's intelligent accounts receivable automation solution. 

Speak to an expert and experience how automated, yet personalized, invoice chasing can transform your cash flow and protect your bottom line.

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