Most companies sell their products on credit, for the convenience of the buyers and to increase their own sales volume. The term bad debt refers to outstanding debt that a company considers to be non-collectible after making a reasonable amount of attempts to collect. These debts are worthless to the company and are written off as an expense.
If a company's bad debt as a percentage of its sales is increasing, it can be a sign of trouble. Therefore, it can be useful to calculate and monitor the percentage of bad debt over time. Here's how to do it.
Calculating the percentage of bad debt
The basic method for calculating the percentage of bad debt is quite simple. Divide the amount of bad debt by the total accounts receivable for a period, and multiply by 100.
There are two main methods companies can use to calculate their bad debts. The first method is known as the direct write-off method, which uses the actual uncollectable amount of debt. Using this number, dividing by the accounts receivable for the period can show the exact percentage of bad debt.
The bad debt expense formula
For example, if a company sells a total of $100 million worth of products on credit during a certain year, and $3 million of this amount turns out to be uncollectible, we can calculate the percentage of bad debt as:
Percentage of bad debt = ($3 million / $100 million) X 100 = 3%
However, this method has a downside. Specifically, companies generally cannot say for sure whether or not a debt is uncollectible for some time after the sales have taken place, which can lead to an inaccurate portrayal of accounts receivable on the balance sheet.
The alternative is called the allowance method, which is widely used, especially in the financial industry. Basically, this method anticipates that some of the debt will be uncollectable and attempts to account for this right away.
Under this method, the company creates an "allowance for doubtful accounts," also known as a "bad debt reserve," "bad debt provision," or some other variation. Companies have different methods for determining this number, including previous bad debt percentages and current economic conditions.
For example, if a lender's bad debt represented 2% of its total loans last year, and the economy has significantly improved since then, it may only decide to set aside a bad debt reserve of 1.5% of its total loans this year.