Accounts receivable is one of the most crucial functions of a business. It ensures that the company physically collects the revenue it makes on paper and does so in a timely manner. Accountants rely on several performance indicators to track progress and facilitate a proactive response to potential problems. The bad debt to sales ratio is one such example.
Before calculating the ratio, managers also need to understand bad debt. Bad debt refers to any amount of money owed to a company that it does not expect to receive. The inability to collect payments happens for various reasons, such as a customer’s bankruptcy or a refusal to pay.
What Is the Bad Debt to Sales Ratio?
This ratio measures the amount of money a company has to write off as a bad debt expense compared to its net sales. In other words, it tells you what percentage of sales profit a company loses to unpaid invoices. A high ratio can indicate that a company’s credit and collections policies are too lax. It can also suggest that the company is having trouble collecting customer payments.
How To Calculate Bad Debt To Sales Ratio
Calculating this ratio requires checking your company records for bad debts and net sales. Calculating bad debt varies across companies and industries because accountants have different measures. For example, a company might decide that anything not paid after 90 days is bad debt. Meanwhile, another company might extend that to 120 days, based on seasonal fluctuations in its clients’ businesses.
Net sales are much easier to calculate. Take your company’s total revenue and subtract any returns, allowances, or discounts. Once you have these two figures, use the bad debt to sales ratio formula below:
Bad Debt Expense / Net Sales
Example of Bad Debt Expense to Net Sales Ratio
Let’s say Company XYZ has total revenue of $100,000. It also has a bad debt expense of $10,000 and net sales of $90,000. This would give Company XYZ a bad debt expense to net sales ratio of 11.1%. Here’s how we arrived at this figure:
$10,000 bad debt expense / $90,000 net sales = 11.1%
How To Improve the Bad Debt Expense to Sales Ratio
Lenders prefer bad debt to sales ratios under 0.4 or 40%. However, most companies prefer to have much lower numbers than this. Unless you have no bad debt, there is room to improve. Here are some ways to accomplish lower bad debt to sales ratios:
- Review your credit policies. Are you granting too much credit? Should you mandate a down payment for new customers? Would shorter terms work better for you? Do you always send your invoices out on time?
- Implement or improve collection procedures. Conduct periodical reviews of your procedures. Are they effective? What can you do to improve them? Could you benefit from outsourcing collections?
- Analyze your customers. Do some customers always pay late? Would it be beneficial to stop doing business with them? What business characteristics do late payers share? Could you offer incentives for early payment?
- Automate the collection process. Automation makes it easier to track payments, send reminders, and take other actions to improve collections. It can also save workers time they would otherwise spend on tedious tasks, such as manual ratio calculations.
Every business faces bad debt risks in one form or another. However, companies that regularly extend credit face higher risks than others. Gaviti streamlines invoicing these customers, tracking payments, monitoring AR performance, and following up with debtors. Schedule a demo to get started.