Your business depends on receivables being paid at an agreed-upon time. However, if it becomes impossible to collect on those receivables, how are you going to deal with the bad debt that’s now on your books?
What is bad debt?
Basically, it is an irrecoverable receivable – a type of expense that occurs when a customer to whom you have extended credit is no longer able or willing to pay you. In accounting terms, this is known as a “bad debt expense” which must be charged against your company’s accounts receivable.
Consequently, because the bad debt expense reduces the value of the accounts receivable on your company’s income statement, bad debt affects your financial projections and cash flow . In addition, the financial harm can spread to other businesses in your ecosystem as well.
Why and how do bad debts occur?
In most cases, the reason is simple: your customer simply cannot pay the bill due to insolvency or bankruptcy.
Your customers may be experiencing delays in payment themselves. They may be enduring supply chain problems that are slowing down deliveries of components they need to manufacture the goods they sell.
Your customer’s bank credit line may have been withdrawn, curtailing his or her operating capital. The market may have turned down suddenly, impacting sales and the overall busines model.
It could also be that you’ve extended credit to an unsuitable customer. If this is the case, you should tighten up your credit control policy to prevent it from happening in the future.
Bad debt can also be the result of credit fraud. For example, your business might have been deliberately targeted by criminals, or a customer misrepresented himself in obtaining a sale on credit from your company, with no intention of ever paying you.
Keep in mind that the first sign your receivables are in danger of becoming a bad debt is late payment of invoices.
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