Trust is integral to doing business. Businesses provide goods or services in good faith that their customers will pay their invoices. When they don’t, it can create significant issues and even hamper the business’s ability to operate. Therefore, managing bad debt carefully is essential for business success.
There’s a difference between debt and bad debt. Regular debt is fine; it’s a standard business practice that lets companies purchase the goods or services they need, then pay later. It’s a legitimate cash flow management technique. However, when normal debt turns to bad debt, it’s a sign that accounts receivable aren’t being managed effectively and companies can find themselves in trouble. It’s essential to be able to identify bad debt and have a plan in place to deal with it before it endangers the business.
Bad debt occurs when the customer, or debtor, either refuses to pay or can’t pay due to insolvency. The true cost of bad debt can include:
1. Inability to operate
Most businesses rely on their income to finance wages, their own debt repayments, the ability to purchase stock or materials, and generally operate as normal. Without that income, businesses are forced to rely on cash reserves for daily operational expenses. This situation may soon lead to depleted cash reserves and escalating debt and if this situation goes on, the business will be unable to operate at all.
If a customer becomes insolvent, it could lead to the business itself becoming insolvent as a result of not receiving payment for goods or services already provided.
3. Increased costs
There are costs associated with chasing bad debt such as lawyers’ fees. There is the opportunity cost of spending time chasing bad debt instead of winning new business. And there is the less-quantifiable cost of stress on the business owners, which can affect their quality of life and even their decision-making.
Making up for bad debt requires a business to win a lot of new customers. Instead of relying on this, it’s important for businesses to put a plan in place to minimise the risk of bad debt and to deal with it as soon as it arises.
Companies should take these six key steps to minimise the risk of bad debt:
1. Conduct due diligence. Before working with a new customer, it’s important to conduct checks including checking their payment history and credit rating.
2. Decide how to work with risky customers. Companies may choose to avoid doing business with risky customers or they could offer tight payment terms to minimise the risk.
3. Offer payment incentives. Companies can encourage on-time payments by offering discounts or favourable terms to those paying early.
4. Discourage late payments. Companies should avoid letting customers get away with late payments, even long-term, trusted customers. It’s not in a company’s best interests to let the debt slide, so they should act immediately to recover the debt.
5. Collect the debt. Use a debt collection service to recover payments more effectively.
6. Take out credit insurance. Trade credit insurance can protect a business from non-payment by making up the shortfall when customers don’t pay. A good trade credit insurance provider will also help businesses conduct due diligence and understand the risk profile of potential customers so the business can make an informed decision.
Every scenario is different and long-term customers with a track record of paying on time may deserve some leeway if they’re having trouble paying this time. But companies need to beware of the slippery slope and put policies and procedures in place for collecting debt before it becomes a drain on company resources.
Mark Hoppe, Managing Director ANZ, Atradius