Too much bad debt could be an indication of trouble. Here's how to calculate it.
Most companies sell their products on credit, for the convenience of the buyers and to increase their own sales volume. The term bad debt refers to outstanding debt that a company considers to be non-collectible after making a reasonable amount of attempts to collect. These debts are worthless to the company and are written off as an expense.
If a company's bad debt as a percentage of its sales is increasing, it can be a sign of trouble. Therefore, it can be useful to calculate and monitor the percentage of bad debt over time. Here's how to do it.
Calculating the percentage of bad debt
The basic method for calculating the percentage of bad debt is quite simple. Divide the amount of bad debt by the total accounts receivable for a period, and multiply by 100.
There are two main methods companies can use to calculate their bad debts. The first method is known as the direct write-off method, which uses the actual uncollectable amount of debt. Using this number, dividing by the accounts receivable for the period can show the exact percentage of bad debt.
The bad debt expense formula
For example, if a company sells a total of $100 million worth of products on credit during a certain year, and $3 million of this amount turns out to be uncollectible, we can calculate the percentage of bad debt as:
Percentage of bad debt = ($3 million / $100 million) X 100 = 3%
However, this method has a downside. Specifically, companies generally cannot say for sure whether or not a debt is uncollectible for some time after the sales have taken place, which can lead to an inaccurate portrayal of accounts receivable on the balance sheet.
The alternative is called the allowance method, which is widely used, especially in the financial industry. Basically, this method anticipates that some of the debt will be uncollectable and attempts to account for this right away.
Under this method, the company creates an "allowance for doubtful accounts," also known as a "bad debt reserve," "bad debt provision," or some other variation. Companies have different methods for determining this number, including previous bad debt percentages and current economic conditions.
For example, if a lender's bad debt represented 2% of its total loans last year, and the economy has significantly improved since then, it may only decide to set aside a bad debt reserve of 1.5% of its total loans this year.
FAQs
Calculating the percentage of bad debt
Divide the amount of bad debt by the total accounts receivable for a period, and multiply by 100.
How do you calculate the percentage of bad debt? ›
Calculating the percentage of bad debt
Divide the amount of bad debt by the total accounts receivable for a period, and multiply by 100.
What is the formula for bad debt? ›
To calculate bad debt expenses, divide your historical average for total bad credit by your historical average for total credit sales. This formula gives you the percentage of bad debt, which represents the estimated portion of sales deemed uncollectible.
What is the percentage of sales method for bad debt? ›
Under the percentage of sales method, the company would multiply the amount of credit sales in the year by the bad debt expense % estimate. The company would then record the additional bad debt expense to the income statement and increase the allowance reserve.
What is bad debt ratio percentage? ›
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.
How to calculate percentage? ›
How Do We Find Percentage? The percentage can be found by dividing the value by the total value and then multiplying the result by 100. The formula used to calculate the percentage is: (value/total value)×100%.
How do you calculate debt formula? ›
You collect all your long-term debts and add their balances together. You then collect all your short-term debts and add them together too. Finally, you add together the total long-term and short-term debts to get your total debt. So, the total debt formula is: Long-term debts + short-term debts.
What is the bad debt method? ›
There are two different methods used to recognize bad debt expense. Using the direct write-off method, uncollectible accounts are written off directly to expense as they become uncollectible. On the other hand, the allowance method accrues an estimate that gets continually revised.
What is an example of a bad debt? ›
Bad Debt Example
A retailer receives 30 days to pay Company ABC after receiving the laptops. Company ABC records the amount due as “accounts receivable” on the balance sheet and records the revenue. However, as the 30 day due date passes, Company ABC realises the retailer is not going to make the payment.
What is the percentage of bad debt provision? ›
Bad-debt provision
| Days past dueDays past due | Percentage balance duePercentage balance due |
|---|
| Days past due60 - 182 days past due | Percentage balance due25% of the balance due |
| Days past due183 - 364 days past due | Percentage balance due50% of the balance due |
1 more rowIn current accounting literature, we usually find three (3) methods of estimating bad debts. These refer to (a) aging the accounts receivable approach, (b) percent-of-receivables approach and (c) percentage-of-sales approach.
What is the most acceptable way to measure bad debts? ›
A bad debt expense can be estimated by taking a percentage of net sales based on the company's historical experience with bad debt. This method applies a flat percentage to the total dollar amount of sales for the period.
What is the formula for calculating bad debt? ›
To calculate bad debt expenses, divide your historical average for total bad credit by your historical average for total credit sales. This formula gives you the percentage of bad debt, which you can also think of as the percentage of sales estimated to be uncollectable.
What is a good percentage of bad debt? ›
In general, many investors look for a company to have a debt ratio between 0.3 and 0.6. From a pure risk perspective, debt ratios of 0.4 or lower are considered better, while a debt ratio of 0.6 or higher makes it more difficult to borrow money.
How to calculate write off percentage? ›
Write-Off Percentage is calculated by dividing the total amount of write-offs by the total amount of charges and multiplying the result by 100.
How do you calculate percentage cost of debt? ›
To find your total interest, multiply each loan by its interest rate, then add those numbers together. To calculate your total debt, add up all your loans. Then, divide total interest by total debt to get your cost of debt. The cost of debt you just calculated is also your weighted average interest rate.
What is a good bad debt write off percentage? ›
These estimates can take into account the business' amount of bad debt from previous periods, economic conditions, and the aging of receivables. Accounting professionals generally recommend that a business' ratio of bad debt to actual write-offs should be approximately 1:1.
What is the accounting equation for bad debts? ›
The other option for calculating a bad debt expense formula is the ageing of accounts receivable formula. This involves taking the total amount of outstanding invoices and dividing it by your average monthly sales, from which you can calculate an estimated bad debt expense.
How do you estimate bad debt expense? ›
A bad debt expense can be estimated by taking a percentage of net sales based on the company's historical experience with bad debt. This method applies a flat percentage to the total dollar amount of sales for the period.
