Bad Debt Expense 101: What It Is And How To Calculate It

bad debt

Many businesses sell their products or services without payment in advance and will experience the frustration of a client not paying their bill. Companies have multiple methods available to avoid this added stress, including offering a small discount for a quick payment — usually within five to 10 days.

But as each day passes and a bill goes unpaid, the likelihood of non-payment increases. An overdue bill by itself doesn’t necessarily mean a client won’t respect their side of the transaction. Often an honest mistake occurs, and the client simply forgot to pay a bill and does so once reminded. 

It is also possible the client ran into an unexpected financial hardship and can only pay part of the bill now and the rest later. As soon as the money owed to a business can’t be collected, the proper accounting terminology for the uncollectable money is simply known as bad debt. 

The majority of entrepreneurs understand that bad debt is part of doing business, and it can’t be avoided. But unsavvy and careless entrepreneurs that encounter their first case of bad debt may need to mitigate the damage by taking out a loan themselves to cover their financial obligations. Fortunately, platforms like Financeraters makes the process of identifying the best loans a straightforward process.

From Receivable To Bad Debt: A Timeline

The best way to understand how an unpaid bill is determined to be bad debt is through an example of a potential timeline.

Suppose a business owner agrees to sell a $10,000 product on 2/10 net 30 terms. This means the client has ten days to pay the bill to take advantage of a 2% discount. Otherwise, the full amount is due within 30 days.

The $10,000 amount is recorded in the business owner’s financial recording software or general ledger as accounts receivable. This refers to any money customers owe and is considered an asset on the balance sheet — not to be confused with revenue.

If 30 days pass and now payment has been received, the bill is now overdue. At this point, the business owner will likely call up the customer and politely remind them of their obligations. If they pledge to pay in a few days, then the debt is considered late but still collectible. 

But if the customer keeps making excuses after 60, 90, and 120 days, it might be time to consider the debt to be bad. 

Jimmy Norin, who is experienced within the fintech field and works with, warns that “at this point, the business owner can pursue legal action to collect the funds or just simply move on. Unfortunately, because of this behavior, this won’t be the first or last time it happens if they continue doing business with them.”

If it is of any comfort, even some of the biggest companies in the world don’t pay their bills on time.

Why Businesses Take A Chance

A common question many ask at this point is, why would a business give away their product or service with no upfront payment? Many Business-To-Consumer (B2C) companies are likely to run some form of a credit check in advance, so they have a higher degree of confidence in the customers’ ability to pay their bills.

But a Business-to-Business requires much more flexibility in their sales practices, especially when it comes to expensive items. Many small businesses won’t have $5,000 in cash lying around when they need to buy a product. But they know for a fact they would within 30 days.

Of course, a business is free to determine its own selling terms. Those that demand cash upfront would effectively be lowering the total addressable market they serve, but it would reduce the likelihood of bad debt to as close to as zero as possible.

Companies that offer extremely generous payment terms, like net 90, could see lower bad debt because it is easier to pay a bill within 90 days as opposed to 30 days. But the downside is the business could end up with cash flow problems because they are just waiting too long to get paid from their customers.

Easy To Calculate Bad Debt

Any business owner that took the time and effort to maintain an up-to-date account of their business can easily calculate the percentage of bad debt over a given period. The method consists of dividing the total amount of bad debt by the total accounts receivable for a given period.

Here is an example: a local business ends the year with $800,000 worth of sales, of which $25,000 was deemed impossible to collect. The ratio of bad debt is =$25,000 dividend by $800,000 is 0.03125, or 3.125%.

This means that statistically, $3.125 of every $100 worth of sales will go uncollected. Businesses could use the prior year’s bad debt metrics in making future decisions, such as altering their price.

How To Account For Bad Debt

Business owners must account for eventual bad debt through a commonly known accounting principle known as the allowance method. This method assigns an estimated dollar amount of uncollectible bills in the same period in which sales are recorded.

There is a lot of logic behind this method as a business owner has no idea or control over what bills are paid on time and which ones aren’t. It may happen that a business goes 51 weeks without experiencing bad debt only for a significant reversal in the last few days of the year.

Reverting to our example above, a business owner will assume that 3.125% of all sales in any given month will become bad debt. If total sales for January were $150,000, then $4,687.50 would be essentially set aside for bad debt.

Here is how it will look like in a general ledger:

Bad debt expense$4,687.50
Allowance for bad debts$4,687.50

Now that a portion of expected bad debt is accounted for, it can be applied for actual future losses. Suppose one month later, a client informs the business owner they are bankrupt and cannot pay a $2,500 bill.

This is perhaps the most obvious case of bad debt and will be accounted for in a new ledger entry as follows:

Allowance for bad debts$2,500.00
Accounts receivable$2,500.00

Bottom Line: Know What You Are Doing

Bad debt expense is a fact of doing business but properly accounting for and managing it is often beyond a business owner’s knowledge. This is why it is crucial for business owners to have good relationships with tax advisors and credit advisors.

The financial fallout from the failure to properly account for bad debt could be a lot more severe than the annual cost of keeping an accountant on retainer.