What Are Bad Debts and How Should You Deal with Them?

Written by

Raja Abbas

Not all debts are equal. Some debt can be good and some can be bad. Think of it outside of the business realm: people get into debt through student loans to attend university. Whilst this debt can lead to financial hardships, it is ultimately “good debt” as the degree means they can work once it’s paid off. But what happens in the business world when these debts are not paid off? We call debts that are not paid back to a business “bad debts”

Table of Contents

The Impact of Bad Debts on Finances

Incurring bad debt has a chain reaction to the internal operations of the business. When a business finds themselves not being repaid for the credit they have given, profit and cash flow are often at risk. 

Profit

When a customer or business fails to pay the debt which is owed to the business, there is a direct impact on the business’s profitability. The sales that would normally occur will compensate for the business’s loss. Extending credit to businesses who cannot repay the debt when it falls due results in a decrease in revenue and an increase in expenses. As bad debts are part of a business’s expenses, any payments which are not made when they fall due disrupt the net income of the business.

Cash Flow

Incurring bad debt has a chain reaction to the internal operations of the business. When a business finds themselves not being repaid for the credit they have given, profit and cash flow are often at risk. 

When a customer or business fails to pay the debt which is owed to the business, there is a direct impact on the business’s profitability. The sales that would normally occur will compensate for the business’s loss. Extending credit to businesses who cannot repay the debt when it falls due results in a decrease in revenue and an increase in expenses. As bad debts are part of a business’s expenses, any payments which are not made when they fall due disrupt the net income of the business.

Bad debts can lead to disruption in your business’s cash flow and disturb liquidity. A decrease in a business’s cash flow can lead to the business falling behind in meeting their own financial obligations (paying suppliers and employees, operating expenses) or even falling behind on repaying debt that they owes to other parties. Having insufficient cash flow will lead to a business’s instability when operating and minimising growth. 

Get 30 days free and 50% off for 11 months with MYOB.

Managing Bad Debts

When facing bad debt as a business, it is important to manage them properly to minimise financial instability. Alongside this, it is important to manage debt that is owed to the business to prevent them from turning ‘bad’.

Bad Debt Letters

Bad debt letters are letters communicated to creditors by businesses to inform them of an outstanding amount of debt that is owed to the business. These letters are a formal notice of unpaid debts and serve as a reminder that the debt must be repaid. This occurs before the debt evolves into one which is ‘bad’ in the attempt to eradicate the possibility of the debt being repaid. In some circumstances, bad debt letters can act as a legal notice to inform creditors that if the amount is not repaid, legal action will be pursued.

Regular Credit Reports

Regularly reporting the credit that is owed to the business is an effective and proactive method of ensuring your business is managing bad debts efficiently. Documenting every transaction in which the business has loaned money or assets to another business can prevent the business from facing unanticipated bad debts.

Write Offs

Bad debts must be written off as they cannot be repaid. Bad debts are expenses due to it causing a financial loss towards the business. In response, managing bad debts by ensuring you write them off is an effective method in ensuring all bad debts are recorded adequately.

Debt Collection Techniques

Communicating to creditors when you are owed debt is important as it may prevent debts from turning bad. There are various debt collection techniques that may be used by businesses in the attempt to gather some or part of the total debt owed. 

Payment Plans

When a creditor is not bankrupt but cannot afford to pay off the debt in large sums of money, the two parties can create a payment plan. Payment plans allow the entire amount or partial amount of debt to be paid back to the business and prevent debt from turning bad.  Payment plans are malleable and can be paid in weekly, monthly or quarterly instalments, with the amount varying depending on the agreement. 

Debt Settlement

Debt settlement refers to negotiating a method of payment or an agreed settlement amount to be paid back to the business. Debt settlement prevents a debt from turning into one which is bad and ensures that at least a portion of the debt is repaid back to the business. 

Legal action may be necessary in some situations, especially if other forms of debt collection techniques have been unsuccessful. In cases where the business refuses to pay any amount, legal action is likely to be the best course of action in order to prevent a bad debt from occurring. It is important to communicate throughout the process of gathering debts as it is likely a less complicated process of collecting debts will arise. 

Preventing Bad Debts in The Future

Commence Credit Assessments and Screenings

Credit assessment and screening is a proactive strategy to minimise the possibility of a business incurring bad debts. Credit assessment and screening involves businesses analysing the financial information of creditors such as credit points, payment histories and financial statements. This should be done before lending money to the organisation and consistently until the amount is repaid, minimising the possibility of unanticipated bad debts as employing this strategy minimises the possibility of lending money to businesses that cannot meet their financial obligations.

Establish Clear Credit Policies

Credit policies are a set of guidelines and rules that businesses establish to govern their credit management practices. A business that has clear credit policies establishes the expected guidelines for expected creditors, reducing the likelihood of engaging with organisations that feel they cannot meet the set requirements. Having a clear credit policy also assists businesses in determining who they lend money to by developing a set of criteria and benchmarks that must be filled. 

Begin Credit Monitoring and Collecting

Credit monitoring and collecting refers to the ongoing process of tracking client’s repayments and how much is owed to the business. When employing this strategy, businesses are able to accurately calculate cash flow alongside determining who and why creditor’s should be contacted.

When dealing with bad debts, there are various legal considerations businesses should ensure they are aware of. When dealing with bad debts, it is important to be compliant with the rules and regulations that govern bad debts.

Contractual Agreements

Contractual agreements are made between creditors and debtors when debt is being given. In response, it is important to review the contractual agreement made to ensure there are legally enforceable terms regarding payment terms, interest rates, late fees and consequences for non-payment.

Credit Reporting

Reporting credits and debts have legal regulations that determine how confidential information is held, ensuring that details are kept private. The Privacy Act of 1988 governs the rules and regulations with credit reporting and ensures that information which is reported to credit reporting agencies is kept private.  

Debt Collection

There are legal regulations regarding the collection of debt from creditors. The Australian Consumer Law (ACL) which is part of the Competition and Consumer Act 2010 applies to debt collection to prohibit misleading or deceptive amounts of cash being asked for. Furthermore, there are debt collection guidelines outlined by the Australian Competition and Consumer Commission (ACCC) which provide acceptable and unacceptable conduct of debt collection.

Conclusion

Overall, bad debts come with various impacts on your business, legal regulations and preventative method. Bad debts have a negative impact on businesses and it is vital to know how to effectively manage and prevent debts from turning bad.

Most Popular Articles
You may also like
Recent Articles

Get the latest news

By clicking on 'Sign up to our newsletter' you are agreeing to the Lawpath Terms & Conditions

Share:

Register for our free live webinar today!

Essential Strategic Planning for the New Financial Year

12:00pm AEDT
Thursday 11th July 2024

By clicking on 'Register for webinar' you are agreeing to the Lawpath Terms & Conditions

You may also like

Want to open a pet shop but not sure how? This article teaches

Thank you!

Your registration is confirmed. Keep an eye on your inbox for an email with details on how to watch the webinar.