A doubtful debt reserve is one way to mitigate the impact of bad debt on your earnings.
Cash flow is the lifeblood of a business, which makes anything that stems this flow a threat to business sustainability. That said, extending lines of credit to customers can be a great way to create goodwill, loyalty, and a fast sale. But if they don't pay, this becomes bad debt.
So what if you only think they won't pay, meaning you haven't marked it off as bad debt yet? Here's where a provision for doubtful debt comes into play. Let's discuss the definition of doubtful debt, how you can plan for it, and how to use credit control for protection against bad debt.
Whereas bad debt is cash that you know a customer isn't going to pay, doubtful debt is cash that you predict will turn into bad debt.
What is the difference between bad debt and doubtful debt?
Whereas bad debt is cash that you know a client or customer isn't going to pay, doubtful debt is cash that you predict will turn into bad debt. Officially, it hasn't become bad debt yet – there's still a chance of reclaiming the lost money. You can use doubtful debt to limit your reported amount of accounts receivable, helping you create a more accurate picture of your company finances. In theory, with doubtful debt being considered early, you'll know more realistically which debts will actually turn into cash and which may be written off.
How does a provision for doubtful debt work?
In accrual-based accounting, a provision for bad debt – also known as an allowance for doubtful accounts or a bad debt reserve – is your way of planning which lines in your accounts receivable may turn into bad debt. This provision is a contra asset account that is paired with (and offsets) your accounts receivable and is a smart tool for militating the impact of bad debt on your company earnings.
One question that often comes up at this point is, how much to put in the reserve? Using past data seems to be the most common way of creating a doubtful accounts provision. If you know that, based on historic earnings, 5 per cent of your sales are generally uncollectible, you would put that 5 per cent aside right from the start to create a reserve.
Ways to limit reliance on doubtful debt using credit control
Smart credit control is one way of mitigating the risk of bad debt and, thus, your need for an extensive doubtful debt reserve. Credit control refers to a broad set of strategies designed to help you get paid quicker:
1. Insurance
Insurance, specifically trade credit insurance (TCI) is your way of helping prevent the negative impact of bad debt on your bottom line. A good TCI provider will offer two products – research and debt indemnification. They will investigate your trade partners to assess credit risk and help you make a strategic decision about whether to proceed. Should your deal go sour and a debt looks uncollectible, your policy can help you recover those funds.
2. Debt Collection
Debt collection is tricky and there's a lot of legislation that surrounds it. It's often wiser, and simpler, to look at partnering with a debt recovery specialist who has experience in your field. For the highest quality service, look for a provider that works fast, charges you only if they are successful, offers world-wide collection and keeps you in the loop at all times.
3. Fast pay discount
Consider offering discounts to customers on their invoice total if they pay within an accelerated timeframe.
Choose a partner that works for you
When it comes to mitigating risks associated with doing business overseas, you need a partner who can work with your needs, wherever your trade partners are. That's where COFACE comes in. As one of the largest TCI providers in the world, we're well-positioned to help assess and resolve payment arrears from your customers and offer personalised advice based on your specific market.
To find out about how we can help you, contact us today for a free quote.