Worried about bad business debts? In this economy, slow-paying and non-paying customers have unfortunately become the norm. They don’t have to impact your company, though. Below, we’ll go over why bad debts happen, ways to avoid them, and how to address them before they become a problem.
In a Business, What Is a Bad Debt?
When you invoice your customers and they’re allowed to pay after goods or services are delivered, you’re extending them credit. However, if, for any reason, the customer does not pay, whether they’re genuinely unable or are simply neglecting your bill, and you’re unable to collect, the amount owed is referred to as a “bad debt.”
How Do Bad Debts Impact a Business?
Bad debts become expenses you pay rather than the income you’re expecting, so your profitability and working capital reduce. That means you have less cash on hand for daily expenses, may struggle to pay your own bills, and may not be able to take advantage of growth opportunities. Depending on the total amount of bad debt a business accrues, it’s possible to become insolvent or go bankrupt as well.
How to Avoid Bad Business Debt
Although businesses may not be able to avoid bad debts altogether, you can reduce the likelihood of bad debts and decrease the total amount of bad debts accrued by applying the following strategies.
1. Credit Check a Customer To Assess Creditworthiness
Many businesses don’t realize that their invoicing process is the equivalent of extending an interest-free short-term loan. In reality, it’s the same as extending credit; not everyone is worthy. Because one of the best predictors of future bill-paying behavior is how payments have been managed in the past, running a credit check before extending credit is the first step to avoiding bad debt.
A credit worthiness check will not only provide you with the customer’s credit score but also highlight issues with late payments and past bankruptcies.
2. Set Realistic Credit Limits
It’s not just about having a good payment history. Your clients must have the bandwidth to be able to cover their debts too. For example, traditional lenders generally won’t touch a company that has a 50 percent or greater debt-to-income ratio, meaning their debts are equal to or greater than their total income. On the other hand, borrowers are looked upon more favorably if their debt-to-income ratio is 36 percent or less.
You can apply a similar strategy. Consider how the money your client will owe you fits into their bigger picture. Only extend an amount of credit that still keeps them within a healthy debt-to-income ratio.
Bear in mind, that their creditworthiness and credit limit may change throughout the duration of your relationship. Therefore, adjusting the terms as your client’s strength changes is okay.
3. Establish and Follow Strict Collection Procedures
Your collection procedures should be made clear to clients and signed off on before any credit is extended. A few areas to address include:
- How creditworthiness is determined.
- When and how invoices will be sent.
- When and how payment reminders will be sent.
- The process and criteria for putting accounts on hold.
- Any penalties customers will accrue if their invoice is not paid on time.
4. Ensure Your Accounting Systems and Processes Are Up-to-Date
It’s impossible to follow accounting best practices and stay on top of accounts receivable without good software. Modern accounting software will automate most of the work to save you time. You can also leverage systems that make it easier for clients to manage their bills. Furthermore, hiring a dedicated accountant or outsourcing your accounting is advantageous.
5. Properly Document Your Transaction
Customer disputes are one of the main reasons even good payers skip out on their bills. If anything is off about the invoice a customer receives, be it the date of service or delivery, the amount, or the item, it can call everything about the invoice into question.
Take special care to ensure all details are accurate and that all invoices include:
- Terms agreed upon
- Delivery dates
- Prices
- Quantities
You should also obtain a signature or other proof that your company delivered goods or services as promised. At a bare minimum, hold proof of delivery until after the invoice is paid. You may want to hold onto the proof longer for legal reasons or for the sake of customer service as well. For example, a client may ask for evidence if they’re performing internal audits.
6. Chase Payment Immediately if a Debt is Overdue
The likelihood of collecting a balance reduces over time. There’s only a 95 percent chance a payment will be collected if it hasn’t been paid before its due date, according to research from the Commercial Collection Agencies of America. At 30 days overdue, collection rates drop to 89 percent. At the 90-day mark, the likelihood of collecting drops below 70 percent. This is especially common with clients who operate under net 30 payment terms, where invoices are typically due 30 days after they’re issued.
This is another reason why sending a reminder of an upcoming due date is essential and is why you must chase unpaid debt as soon as a deadline is missed.
7. Don’t Delay Putting Delinquent Accounts on Hold
Because the likelihood of payment decreases as a balance ages and decreases as a business’s debt-to-income ratio increases, clients should not have the opportunity to add to their balances once a due date is missed. Ensure your order-tracking software and/or CRM are set up to trigger an alert and prohibit further debt accrual when payment is missed.
8. Factor the Potential for Payment Delays into Your Cash Flow Forecast
All businesses will likely face slow-paying and non-paying clients at some point in time or another. It’s important to build a cushion into your budget to ensure you have enough cash on hand to manage expenses when this happens. Although it won’t prevent bad debts, it can ensure your business doesn’t suffer in the long run when you’re hit with cash flow issues.
9. Consider Invoice Factoring
Invoice factoring companies are often leveraged because they can help businesses increase cash flow by providing advances on unpaid B2B invoices, but they can also help you avoid bad business debts. For example, transportation factoring is a popular option for trucking companies that need immediate cash for fuel or repairs while waiting on long payment cycles. Most factoring companies will credit check a customer for you, then let you know who is creditworthy and how much credit can be extended. Factoring companies can also handle the collection of debts for you, so invoices get paid without your team having to chase them. The improved collections process also means payments are more likely to be made on time. However, because payment is made to you as soon as you submit your invoice to the factoring company, it won’t dramatically impact your cash flow if a client pays a little late.
Many small businesses also turn to factoring for small businesses to manage their cash flow challenges effectively.
Get Started with Viva
With decades in the industry, a rapid approval process, same-day funding, and competitive rates, invoice factoring from Viva Capital can help you avoid bad business debt and manage cash flow more effectively. Request a free rate quote to get started.
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