Debt refers to the amount of money one entity owes another. Debt becomes bad debt when the debtor has a low or no chance of repaying that money. When financial professionals calculate a bad debt to sales ratio, the intention is to determine the financial state of the company. More specifically, the accounting team needs to determine its ability to repay its debts if liquidated at a specific time.
What Is Your Company’s Debt to Sales Ratio?
Financial professionals reflect the ratio as either a decimal or a bad debt percentage. For example, you might see it written as .5 or 50%. Most experts agree that a ratio of 0.4 or 40% represents a good possibility of the company repaying its debtors. In contrast, anything above .5 or 50% represents high risk and low equity. Accounting professionals use two main methods to account for this.
Direct Write-off
Accountants use this bad rate formula to calculate the amount of debt they believe is uncollectible. They then spread out the debt across a predefined period. Companies that use cash accounting tend to use this method. Accountants also use this method for U.S. taxes.
Example:
- Annual Sales = $1 million
- Uncollectible = $20,000
(Uncollectible / Annual Sale) x 100
(20,000 / 1,000,000) x 100
0.02 x 100
2%
Allowance Method
Also known as the allowance for doubtful accounts ratio, this option better suits the matching principles of accrual accounting. It requires accountants to prepare for the risk of bad debts, estimate a certain amount and set aside a matching allowance account. The initial number comes from calculating bad debt expense percentage sales from the previous year or another predetermined period.
Example:
Doubtful Debt: $5,000
When accounting for the doubtful debt, the accountant records the $5,000 as a debit in the bad debts accounts and adds a matching credit entry of $5,000 to the allowance for doubtful accounts. If a doubtful debt becomes a bad debt, you then need to add a credit entry to your accounts receivable account.
Why Is It Important To Know Your Bad Debt To Sales Ratio?
Any performance indicator for your business is worth reviewing to ensure you keep a close eye on different aspects of its financial strength. Even so, this one is of special importance. Here’s how knowing the bad rate formula and resulting ratios can protect your business:
- You can set a ratio point to indicate when it’s time for your business to take more drastic accounts receivable strategies.
- You can review the financial data of customers that tend to create bad debt problems for your company, so you can set better credit criteria.
- Use it to ensure you have the data you need on hand to determine your leeway for investments beyond just cash flow projections.
- Use a good debt ratio to bolster the attractiveness of your business to investors, so you can source more capital for long-term growth.
What Can Companies Do To Lower Their Debt Ratios?
The common-sense approach to reducing your business’s debt ratio involves increasing sales and decreasing debt. Accomplishing this, however, requires serious planning and commitment to improving cash flow and equity. Consider the following options.
Rely on Additional Data
While your debt ratio provides crucial information you need, it isn’t the only important performance indicator you need to review. Of equal importance are your aging accounts, sales turnover days and your days sales outstanding. These additional indicators help you determine the effectiveness of your current accounts receivable strategies. Leverage the power of technology to ensure you always have real-time information for these and other KPIs.
Pay Off Loans Early
Some lenders penalize debtors for repaying loans early. If this is the case for your loan, calculate the fees vs the benefits of repaying it ahead of schedule. Early repayment will remove one debt from your list now that you might struggle to pay later.
Refinance Debt
Borrowing money is expensive, but as your business and your credit accounts age, you become eligible for more favorable terms. Reach out to your creditors and shop around to determine whether you can refinance the debt you owe at more favorable rates.
Find Higher-Paying Clients
Cost and credit are not the only factors your customers take into consideration when they choose to work with you. They also make decisions based on value. Even if it means offering a few extra perks to gain more income from some customers, consider raising prices. Here are some options you could charge more for:
- Providing dedicated account managers for premium customers
- Offering faster delivery services for premium customers
- Bumping higher-paying clients to the front of the line for scarce resources
- Giving higher-paying clients first pick of goods or services where applicable
Most business owners prefer to have no debt if they can help it, especially small business owners. However, some debt is a good thing. It helps to build business credit, so you can get better rates should you really need credit in the future. Ironically, using credit can also protect the cash flow and on-demand-liquidity of your business. Consequently, financial experts recommend shooting for a bad debt percentage of 15% to 20%.
