Say the word “debt” and most people will cringe. It is ingrained in the collective consciousness as something negative, but debt is not a boogeyman to avoid at all cost. Companies take on debt to invest in growth initiatives, while consumers borrow to buy homes, cars, furniture, and household appliances. And thus the wheel of the economy keeps turning on.
Problems arise when companies have to deal with bad debt. Many businesses rely on trade credit to grow revenue so when customers cannot pay their dues, the debt goes bad. Uncollectible receivables can be written off as expenses, which may seem like a handy solution. However, there are cases when writing off bad debt is actually the wrong route to go and may hurt your bottom line.
Write-offs mean giving up on collection
While uncollected payments can put your business under great stress, there is still the possibility of getting your money, often with interest. When you take the write-off road, you are officially declaring you don’t expect to collect the receivables. In other words, you close for good the door on pursuing payment. Debtors walk away scot-free and your income suffers.
Making up for write-offs can be very hard
Bad debts are obviously detrimental to business but writing them off should not be undertaken lightly. That’s because the compensation costs can be very high, sometimes making the payment owed pale in comparison.
Here’s an example that illustrates the consequence: if you write off $10,000 and have a 5% profit margin, you need $200,000 in extra sales to make up for the write-offs. Obviously, your bottom line will take a hit.
It might be best to exhaust all other options before resorting to write-offs. An experienced commercial litigation lawyer, for example, can provide creative solutions for dealing with delinquent accounts.
Debt write-offs can impair financial management
This is typically the case with the accounting method known as a direct write-off, where the liability is entered into the income statement. Despite providing a more accurate picture of a company’s financial situation at a given point in time, this method doesn’t allow for much proactive debt mitigation, as is the case with making bad debt provisions in advance (the allowance method).
In the final analysis, business owners should tread very carefully when considering bad debt write-offs. It’s true that this course of action is justified in some cases, for example when a client goes bankrupt or the amount due is small.
Most often, however, it’s best to consider alternative solutions for collecting an overdue payment. You can use the services of a debt recovery firm or sell the debt to an invoice financing company. Another possibility is bringing the issue before a claims court although legal recourse usually takes more time and money.
As with most things in business, taking the necessary precautions is the best way to go. To prevent late payments and the potential necessity for write-offs, you should conduct thorough credit checks on new customers. You could also consider investing in insurance against bad debt.