Have you ever lent money to a friend who promised to pay you back but never did? That uncomfortable feeling is exactly what businesses experience with bad debts.
Bad debts are amounts of money that someone owes you but will probably never pay back. When customers fail to pay what they owe, these unpaid amounts turn into bad debts.
Simple Example: Imagine you run a small bakery and allow regular customers to buy bread on credit—they take the bread today and pay you next week. If one of those customers never returns and never pays, that unpaid amount becomes a bad debt.
In the business world, companies often sell products or services on credit to attract more customers. It's like expecting payment for work you've already done, but that payment never arrives.
Bad debts occur for various reasons, ranging from genuine hardship to intentional fraud:
Customers face genuine financial problems. Someone who bought a laptop on installment might lose their job and can no longer make payments.
Customers move to different countries without settling bills, making it nearly impossible to track them down and collect payment.
Some customers take goods without ever planning to pay—essentially theft through credit fraud.
Natural disasters, economic downturns, and business failures make even well-intentioned customers unable to pay.
Maria, a freelance graphic designer, completed a logo design project for a startup company. The contract was for $2,000, payable within 30 days of project completion.
Maria delivered excellent work, but the startup ran out of funding and shut down before paying her. That $2,000 became a bad debt, representing hours of work she'll never be compensated for.
A furniture store sold a dining set worth $3,500 to a customer on a twelve-month payment plan.
After making just three payments, the customer stopped responding to calls and emails. Despite multiple contact attempts, the store had to accept that the remaining balance wouldn't be recovered.
A textile manufacturer in Bangladesh supplied fabric worth $50,000 to a clothing retailer in South America.
The retailer received the goods but filed for bankruptcy before making payment. Despite legal efforts, the manufacturer could only recover about 10% of the amount, making the remaining $45,000 a bad debt.
Bad debts hurt businesses in multiple ways, creating both direct and indirect financial challenges:
The obvious loss of money that was expected but never received. This affects cash flow—the money moving in and out of a business. When payments don't arrive, businesses might struggle to pay their own bills, suppliers, or employees.
Businesses spend time and money trying to collect unpaid amounts through phone calls, emails, and sometimes legal action. These collection efforts require staff time and resources that could be used for serving customers or developing new products.
For small businesses especially, bad debts can be catastrophic. If a small catering company has bad debts amounting to 15% of its annual revenue, that could mean the difference between profit and loss for the entire year. Owners might have to dip into personal savings or cut employee hours to survive.
Smart businesses take several steps to minimize bad debts before they occur:
Verify whether potential customers have a good track record of paying their bills before offering credit—just like banks check credit history before approving loans.
Cap the maximum amount a customer can owe at any time. For example, no customer can purchase more than $5,000 worth of goods on credit, limiting potential losses.
Offer small discounts for early payment to encourage quick settlement. For instance, a 2% discount if payment is made within ten days instead of thirty days.
Require deposits or partial payments upfront. Wedding photographers often require 50% of their fee upfront, reducing risk if the client disappears.
Establish and communicate clear policies about payment deadlines, late fees, and consequences of non-payment from the beginning.
Send timely reminders before and after payment due dates to keep customers on track and catch issues early.
When a business finally accepts that an amount will never be recovered, it must officially recognize this loss through a process called writing off. This doesn't mean giving up legally, but acknowledging the financial reality that the money is gone.
The write-off affects the business's financial statements significantly. It reduces both the assets (because the receivable amount is removed) and the profits for that period. If a bookstore writes off $8,000 in bad debts, its profit for the year decreases by that amount.
Tax authorities in many countries allow businesses to deduct bad debts from their taxable income, which provides some relief. If a company writes off $10,000 in bad debts, it might save $2,000 to $3,000 in taxes, depending on the tax rate.
Writing off a debt doesn't eliminate the legal right to collect. Businesses can still pursue legal action later if the debtor's circumstances improve, but they're recognizing the current financial reality.
Bad debts are an unavoidable part of doing business. Even the most careful companies with excellent credit policies will experience some level of bad debts. The key is managing them effectively so they don't threaten the business's survival.
For Aspiring Entrepreneurs: Understanding bad debts is crucial when starting a business. It affects how you price your products, whom you extend credit to, and how you manage your cash flow.
The Balancing Act: Every successful business has learned to balance the benefits of offering credit to customers against the risk of bad debts. It's about finding the sweet spot where you attract customers with flexible payment options while protecting your business from excessive losses.
Building Resilience: Creating a financial cushion in your budget to absorb potential bad debts is just as important as planning for rent and salaries.
The next time you hear about a company's financial challenges, bad debts might be part of the story. Understanding this concept helps you see the complex reality behind business decisions and why companies sometimes have strict payment policies that might seem inconvenient to customers.