THE COST OF BAD DEBTS
By Mark Logue
What are the cost of bad debts? What is the correct approach to opening a new account? This update discusses the importance of financial risk and credit management to all businesses that provide trade credit.
The onset of the Global Financial Crisis in 2008 brought about significant and ongoing change in the Australian business environment. Risk management is now high on the agenda; banks have reduced lending to businesses (in particular to small businesses), large businesses are monitoring their accounts receivable more closely than ever before, and consumers have all but stopped spending money.
A business’ accounts receivable is often one of its largest assets and provides the cash flow necessary to prosper and grow in these challenging and changing times. Quality credit management is a key element of strong cash flow. If practiced correctly, it will support the company’s cash flow requirements and contribute to growth and profitability by minimising the incidence of overdue accounts and bad debts.
The key elements of quality credit management revolve around:
§ Credit documentation
§ Account set-up and maintenance
§ Verification of customer information
§ Overdue account procedures
Here we will outline a quality approach to credit risk management, which can be adapted to suit the specific requirements of almost any business, particularly those in the small-to-medium business sector.
Whenever an organisation provides credit, there is a risk that the account may not be paid on time. In addition, the longer a debt remains outstanding, the likelihood of it never being paid increases. Quality credit management is a combination of good internal procedures, quality documentation and swift, decisive action.
Below is a table, which identifies the cost to business of writing off bad debts, and illustrates the additional sales revenue, required to offset a bad debt. If a business generates a profit of 10%, and suffers a bad debt of $10,000, it will need to increase sales by $100,000 to negate the effect of the bad debt.
What are not represented here, are the indirect costs associated with carrying the bad debt. These indirect costs include the cost of replacement capital, the labour costs associated with chasing the debt and the opportunities lost as a result of diverting resources to chase overdue accounts.
Net Profit Percentage
Above: The impact of bad debts on sales
The good news however, is that it is not expensive to improve the management of credit. An investment of time and a commitment to implementing quality practices, procedures and documentation will pay handsome dividends almost immediately.
A key part of a good credit policy involves selecting the right partners to assist you along the way. This includes your choice of collection agency. Generally, the services of a collection agency will include:
§ Recommending the most appropriate and cost effective debt recovery strategy for each matter
§ Issuing written and telephone demands for payment
§ Locating debtors and conducting field calls when required
§ Handling inbound debtor queries resulting from the demand process
§ Establishing and managing both formal and informal debtor payment arrangements
§ Commencing legal action, and carrying out enforcement when necessary
§ Identification of debtor assets
§ Reporting on the performance of individual matters as well as the overall portfolio
§ Liaising with field agents, process servers, solicitors and the courts
§ Carrying out searches of company and property registers
§ Assisting clients to improve their terms of trade where appropriate