Whether you are a brand new start up or an experienced entrepreneur, it’s vital for businesses to know that not all customers can or will be able to pay their bills.
It's a harsh reality to face.
Some customers simply choose not to pay their bills, some think they can, but then they can't. Unfortunately, this is a risk entrepreneurs take when running a business. But there are some ways to deal with unpaid accounts receivables, financially.
Most businesses categorize unpaid bills as “bad debts expense”, and write them off at the end of each year. This is so common that most modern accounting principles and practices (Generally Accepted Accounting Principles [GAAP]) require businesses to reflect the bad debt expense in financial statements. It's important for every company to follow a bad debt expense formula for estimating and calculating bad debt expense.
So, how do you calculate bad debt expense? What is the bad debt expense formula? Is it even accurate?
Let's take a look at how the bad debt expense formula works. Then look at how businesses can avoid inaccuracies in bad debt expense estimates.
How to Calculate the Bad Debt Expense Formula
First, how do you calculate the bad debt expense? The percentage of sales method is one way to estimate bad debts expense as part of the income statement. The percentage of sales method figures the bad debts expense as a percent of credit sales for an accounting period.
A percentage of sales figure is based on how your sales have performed over the years, as well as other financial factors, like any changes in the company’s credit policy. In the percentage of sales method, the balance in the allowance for doubtful debts isn’t included or considered.
The bad debts expense is calculated using the following formula:
Bad Debt Expense Formula:
Bad Debts Expense = Estimate % X Credit Sales
Example of Using the Bad Debt Expense Formula
For example, let’s say that ABC Construction’s total credit sales at the end of 2016 were $300,000. The company estimated that 5 percent of its credit sales will remain unpaid or as bad debts. The allowance for doubtful accounts for the business showed a credit balance of $5,000 at the close of 2016.
If we were to follow the bad debt expense formula, then the solution would look something like this:
Bad Debts Expense - 5% x $300,000 = $15,000
How Accurate is the Bad Debt Expense?
Now that you have a better understanding of how the formula works, how accurate is it? Although estimating bad debts expense involves a historical analysis of financial trends and a company’s performance, there are also some data biases in estimating an allowance for doubtful accounts.
Therefore, calculating bad debt expense is not as cut and dry as businesses would like.
Here are some ways on how to accurately calculate bad debts expense.
Compare bad debt expense to write-offs.
Bad debts expense recorded in a specific year may not necessarily be the exact cost of estimated bad debts expense for the given year. In fact, it's unrealistic to expect the two sums to match.
So, be sure to compare bad debts expense to write-offs from previous years to form a realistic judgment for the current year.
Detect possible collection problems.
After analyzing bad debts expense and write-offs ratios for each given year, and for multiple consecutive years, you may discover that you have an unhealthy trend. This is a sign of a collection problem. This might also signal that companies are accumulating an excessive allowance.
In addition, analyzing and comparing bad debts expense to write-offs, year-over-year can provide insights related to the relationships between the two figures over a period.
Avoid making poor investment choices.
When you think about it, most businesses spend more time and resources on trying to collect from bad accounts when compared with the accounts in good standing. When customers pay on time, no extra work, or labor is required.
It takes little effort to keep customers’ accounts in good standing when bills are paid on time. Managing current accounts requires little time, money, and resources.
However, bad debt expense ends up costing companies far more than the amount that is in default. Therefore, companies should focus less time on the areas of the business that are poor investments.
In an effort to combat bad debt expense inaccuracies, and to improve bad debts expense, implement an automated billing process, tighter credit approval for customers or revisit your current credit policy.
Review your sales method.
Another way to drop bad debts expense is to pay closer attention to your daily sales outstanding (DSO). DSO is the average amount of time invoices go unpaid. The longer invoices remain outstanding, the less likely a customer is going to pay.
Companies can easily look back on customer accounts year-over-year to get a feel for their payment history and track record to better estimate bad debts expense.
Calculating the Bottom Line
Bad debts expense, accounts receivable turnover ratio, and daily sales outstanding (DSO) are all numbers that businesses need to understand and closely monitor. These numbers show you a lot more about your company’s financial performance than what you might think.
They might also force you to rethink your company’s credit policies .