How to Prevent Bad Debts in Business
Preventive measures against bad debts.
What is “bad debts”? In a simple language, I will define bad debts as sales made to customers on credit which you are not able to collect. On the other hand, one can say that bad debts are irrecoverable debts. Bad debts as its name implies is bad for any business.
It does not only distort your financial reporting, it also affects your liquidity. Let me explain this. In accounting, you prepare your financial statements using accrual concept. This implies that you recognize your revenues when sales are made. You don’t wait till the time you collect money from your customers before you capture your income. Following this concept, it means that you have to capture all your sales as revenues in the period in which the sales occur. For instance, if you sell goods worth one thousand dollars to a customer on credit with the promise that he will pay later, you need to capture that one thousand dollars as income in the period the sales are made. Perhaps by whatever reason, the customer fails to pay back the one thousand dollars which you have captured as income, this amount becomes a bad debt. Consequently, you need to recognize the one thousand dollars which is now a bad debt as part of your overheads. This amount will reduce the amount which you must have recorded as income or profits before in the income statement of your business. That is why I say that bad debts distort financial statements.
Let’s look at the other effects of bad debts on cash flow. Before you can sell an item to a customer, you must have bought it from a supplier either in cash or on credit. If you bought it on cash, both your profit and the money invested in buying the item are totally lost if your customer refuses to pay. This will make it impossible to replenish the item except you source for money elsewhere. The situation is even worse if you borrowed the money you used to buy the item from the bank or other money lender. You will not be able to pay back the money on time and the interest will keep accruing on the loan. This can jeopardise your credit rating. You may not be able to access credit facility easily in the future.
Supposing you bought the goods on credit, you have the obligation to pay the supplier whether your customer pays you back or not. If your customer fails to pay, it becomes difficult for you to pay your supplier too. Failure to pay your supplier on the agreed date may lead to a strained relationship. Your supplier may not be willing to extend another credit to you as he may see you as somebody who is not credit worthy.
There is nothing good about bad debts. It can cripple any business whether small or big. That is why you should do all you can in order to avoid it. Below are the steps you can take to prevent bad debts.
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Sell on cash
The best way to avoid bad debts is to sell on cash. If you don’t sell on credit, you won’t have bad debts. I went to buy something in a local shop one day. The inscription I saw on the signage at the entrance of the shop actually caught my attention. It was boldly written there: “No Credit Today, Come Tomorrow”. The message is simple but very clear. The owner is simply saying that he doesn’t sell on credit. If you go there the following day, you will still meet the same words. This means that the ‘tomorrow’ he told you to come will never come. This is a tough decision to make especially if you operate in a competitive market. But this will save you head ache. You will not have to spend your days calling and chasing after debtors. You will be able to concentrate on your business doing what needs to be done. If someone promises to pay on delivery, it is advisable to receive your payment before handling over the item to such person.
Carry out background check on your customers
Because of the competitiveness of the market, you may decide to sell to customers on credit. There are certain highly priced items that most of the customers may not be able to buy on cash. In this case, you may need to sell on credit. However, selling on credit should not be for all comers. You need to carry out background check on your customers to determine their credit worthiness. There are certain customers that are keen in shopping around. They are not loyal to any seller. They shop for two or three times. Immediately they succeed in buying on credit, they will disappear into thin air. If you are to sell on credit, you should sell to people you know very well. You should be able to vouch for their credit worthiness. If you don’t know them personally, ask about them from the people you trust that know them. Please you should be able to separate ‘knowing somebody’ from being ‘credit worthy’. You close relation that you know may not be credit worthy. Therefore, if you are in doubt of the credit worthiness of any person, it is better to play save by not extending credit to such people. There is no sentiment in business.
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Have a credit policy/credit limit
It is not enough to carry out background check on your customers. If you decide to sell to customers on credit, you must establish a credit policy. Your credit policy may be thirty days credit. This is most popular. Nevertheless, your credit term should correspond with the type of products you sell. You should also bear in mind the credit term you enjoy from your suppliers. I don’t expect the credit term you offer your customers to be longer than what you enjoy from your suppliers. The shorter your credit term the better because the longer a customer owes you, the more difficult it becomes to recover the debts.
You should also have a ceiling for the amount of credit you extend to your customers. You may decide that your credit sales should not be more than a certain percentage of your total sales. If majority of your sales are on credit, it will be difficult for you to replenish your inventories. Furthermore, you should set credit limit for each of your customers. All your customers cannot have the same buying and paying capacity. You need to identify each customer’s capacity to pay. That will determine the level of credit you will extend to them.
Invoice customers on time
Time is money. Your credit term starts counting when you issue an invoice to your customer. You need to send out your invoice as soon as possible so that you can get paid on time. It is very important that you stipulate your credit terms on your invoices. You should not assume that your customers should know this by themselves.
Contact your debtors regularly
A lot of people make the mistake of waiting till the time the credit term expires before start calling their debtors. This is wrong. You can call your debtors in a friendly way without necessarily harassing them to remind them about their debts. Naturally, it is easy for people to forget about what they have already consumed. Some of the debts that turn bad may be as a result of lack of adequate follow up on the debtors. If you refuse to contact your debtors, they may assume that you are comfortable. They, too, will become comfortable with the debts. Before you know what is happening, it will become bad debts.
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Offer cash discount
The word ‘discount’ is attractive. Supermarkets owners understand this trick. Therefore, you can offer cash discount to your debtors. You may be surprised that some of them may like to take the advantage of the discount by paying on time.
I believe that taking the steps enumerated above will help you minimize bad debts in your business.