How Startups Can Handle Bad Debts: Navigating Through Troubled Waters
What a bad debt is, the five methods for estimating it, the four types, and how to collect each. Researched notes from a software person learning finance.
For this one, I was curious. As someone dreaming of starting my own business, understanding how to manage finances, particularly bad debts, seemed pretty important. And I thought it was worth sharing what I learned/learning with you!
As we move forward in this article, here is how I thought about it:
- What is a bad debt?
- Methods of estimating bad debts
- Types of bad debts
- Best approach to collecting debts (not the bat)
If you know other ways, or if I explained something wrong, please leave it in the comments and I will edit the article.
What is a bad debt?
What I understood
Someone owes you money, and for one reason or another, you can't collect it. Now you have to remove it from your accounting books. I don't think it could happen in the software industry easily, maybe that's why I was never exposed to a similar situation before.
More details
Bad debt refers to money that is owed to a business but is unlikely to be paid by the debtor. This situation typically arises when the debtor faces financial difficulties and cannot fulfill their payment obligations. Bad debts are considered a loss for the business and can negatively impact its financial health.
Key aspects of bad debt
- Recognition: A debt is often categorized as "bad" after all reasonable collection efforts have been exhausted and it becomes apparent that the likelihood of recovery is minimal.
- Financial impact: Bad debts result in a direct loss of revenue for the company. They must be written off the company's accounting records and reflected in the financial statements as an expense.
- Accounting treatment: In accounting, businesses often create an allowance for doubtful accounts, which is an estimate of the total amount of receivables that will not be collected. This allowance is used to offset the gross accounts receivable balance (still learning what is this!!) on the balance sheet.
- Tax treatment: Depending on the area/region/country, companies might be able to claim bad debts as a tax deduction, which can mitigate the financial impact.
- Risk management: Companies can manage the risk of bad debts through credit checks, stringent credit policies, and sometimes by purchasing credit insurance to cover potential losses. Makes sense if you work in products I think, but in software, this is much harder.
Bad debts are a common risk in business, particularly in industries where credit sales are prevalent. Effective management of receivables and proactive debt collection strategies are crucial for minimizing the occurrence and impact of bad debts.
Methods of estimating bad debts
There are several common methods used to estimate bad debts, and each one is suitable for different business environments and accounting practices.
Each of these methods has its advantages and disadvantages, and the choice of method can depend on regulatory requirements, the nature of the industry, the size of the company, and the stability of the customer base. The goal is to provide the most accurate estimate of bad debts to ensure that financial statements reflect a realistic view of the company's financial position.
I will write what I understood; if you want more info, you can check the references, Google or ChatGPT.
1. Percentage of Sales Method
If you have historical data (as a startup you don't usually), then you put it as an expense of a percentage of your sales.
2. Aging of Accounts Receivable Method
Also needs historical data: categorize your debts based on how long they were not paid, and then assign a percentage of bad debts to these categories. The older the debt, the higher the probability it will not get paid.
3. Historical Percentage Method
Similar to the percentage of sales method but applies a historical bad debt percentage to the ending balance of accounts receivable. More suitable for economic challenges (as per my understanding).
4. Specific Identification Method
Individual debts are reviewed, and a determination is made regarding their collectibility. Often used for larger accounts where the financial status of each debtor is known and can be individually assessed.
5. Write-off Method
As soon as you feel it is not collectible, it is removed from the books. Not accepted from an accounting perspective, but can be considered if the amount is insignificant.
Types of bad debts
Bad debts typically arise in different scenarios based on the context of the debt and the nature of the debtor. Here is what I found:
- Commercial bad debts: These occur in business-to-business transactions when one business fails to pay another. The inability to pay may be due to financial failure, bankruptcy, disputes over the goods or services provided, or other business-related reasons.
- Consumer bad debts: These arise from transactions between businesses and individual consumers. Common examples include credit card debt, personal loans, and medical bills that are not paid.
- Secured bad debts: In these cases, the debt is backed by collateral (car, house, etc.). If the debtor fails to make payments, the creditor has the right to seize the collateral to recover some or all of the debt. However, if the value of the collateral has depreciated or cannot fully cover the debt, the remaining amount becomes a bad debt.
- Legal bad debts: Sometimes, a bad debt is categorized as such after legal proceedings determine that the debtor is unable to pay due to bankruptcy or insolvency. This is a formal recognition that the debt cannot be collected.
Best approach to collecting debts
1. Commercial bad debts
- Preventative measures: Conduct thorough credit checks before extending credit and establish clear credit terms upfront.
- Negotiation: Businesses can engage in negotiations to restructure the debt, offering payment plans that may be more manageable for the debtor.
- Legal action: If negotiations fail, legal action may be necessary. This might involve filing a lawsuit or using arbitration if previously agreed upon in the contract.
2. Consumer bad debts
- Communication: Early and frequent communication with the debtor can help resolve issues before they escalate.
- Flexible payment arrangements: Offering structured payment plans can sometimes recover funds that would otherwise be lost.
- Debt collection agencies: For difficult cases, employing a reputable collection agency that complies with local laws can be effective.
3. Secured bad debts
- Seizure of collateral: The first step is often to reclaim the collateral that secures the debt. Ensure that this process is handled legally and sensitively to avoid further complications.
- Reselling collateral: After seizing the collateral, the next step is usually to sell it. The proceeds from the sale are used to cover the unpaid debt.
- Deficiency balance actions: If the collateral does not cover the full amount of the debt, pursuing the deficiency balance through legal means may be necessary.
4. Legal bad debts
- Bankruptcy claims: File a claim in the bankruptcy proceedings. Recovery might be partial and dependent on the proceedings' outcomes.
- Monitor legal proceedings: Stay informed about the legal process, and ensure your claim is registered and acknowledged in any settlement or restructuring.
References
Not a personal experience this time!
- What Is Bad Debt? Write Offs and Methods for Estimating
- Estimating Bad Debts
- Canada Revenue Agency: Bad Debts
- ChatGPT of course
Where Taqdim fits
A bad debt is effort you already spent and can't recover — which is why we think effort should be screened before it's spent. Taqdim helps job seekers decide which applications are actually worth their hours. Taqdim is in closed beta. Join the waitlist.
Originally published on Medium on 21 Apr 2024.