Bad debt. Yuck. Nobody wants to have it and those that do want to get rid of it fast. When it comes to small businesses, what they really want to know is “Can I write off bad debt?” If you’re a business that extends credit to customers then, yes, you’ll definitely be in a position to write off debt. However, it’s important to understand just what it means to write off debt, the effect it has on your business, and how you can prevent ever needing to do so.
Remember this: when you extend credit to customers, you *technically* earn your money as soon as the goods or services are delivered. As you know, your receivables are added to your books until you get paid or stop pursuing payment.
Now remember, your receivables are listed as current assets. Why? Because you are under the assumption that they will become cash by the end of the year. However, when you operate on trade credit, you are considered an unsecured creditor. In short, if the debtor declares bankruptcy, you are not protected. This does not apply if your business comes under a lien statute in your state. If you can’t file a lien, be prepared to write off some of your receivables.
So, what should you do when writing off your unpaid receivables? Whatever you do, don’t be optimistic. Try to give a solid estimate of the receivables that you don’t think you’ll get a check for. You don’t need to list which debtors won’t pay or the precise amount that won’t be paid. You do need to estimate how much you don’t think you can collect. You are required to use the direct write-off method when dealing with your receivables. The most important thing to remember is that you can only write off the receivables when you actually give up on collecting them. You may be asking, “When is the right time to give up?”
Well, when an account is over 90 days past due, it has become near impossible to collect. That’s one indicator. Also, if you have repeatedly tried to contact a customer about payment and haven’t had a single reply, then there is probably no hope. However, remember that writing off bad debt is not a good thing for your bottom line. You are saying “I give up” AND you are also losing cash your company has earned. In fact, the effect on your business is quite large. Compensating for write-offs is not an easy task. Just take a look at this figure:
If you had $15,000 in write-offs last year and a profit margin of 5%, you would need $300,000 in additional sales to compensate for your write-offs.
Yikes! It’s nuts to think just how much you lose when writing off bad debt. The goal is to position yourself so you never need to “give up” on your debt. You must make your receivables management a top priority, ensuring no invoices fall through the crack. Stay persistent about getting those unpaid invoices paid. It’s a commitment, but one well worth it. If you get to the point where you think you just might have to write off debt, try another option before doing so, like sending the invoices to collections. Although a last resort, it makes more sense financially. And despite any horror stories you might have heard, there are some top-notch collection agencies out there. The key is to simply ask the right questions to ensure you end up doing business with the right agency.
Curious how many additional sales you would need to make to compensate for your write-offs? Use this free write-offs monitor to calculate!