The term bad debt percentage refers to the total amount of accounts receivable that will never be collected from customers. The bad debt percentage is a function of both the company's credit policy as well as the effectiveness of their collections processes.
Bad Debt Percentage = Total Bad Debts Recognized / Total Credit Sales
Accounting and finance metrics allow a company's internal analysts to understand how well its accounting and finance departments are operating. This is usually assessed by examining metrics such as error rates, transactions processed, discounts taken, and turnaround times. Accounting and finance metrics allow the company's management team to identify areas where changes can be made that will improve their key operating metrics. One of the ways to learn about the effectiveness of the company's credit policy and collections process is to calculate its bad debt percentage.
A company's accounting, finance and collections departments are usually responsible for determining the policy that allows customers to make purchases on credit. Once a sale on credit occurs, it is the responsibility of the company's accounts receivable and collections teams to manage the dunning processes which will attempt to collect the dollars owed the corporation. One of the ways to measure the effectiveness of these policies and processes is to measure the company bad debt percentage. Since this value will vary by industry, performance should be benchmarked against companies in a similar or the same industry.
The CFO of Company ABC wanted to understand if customers were taking advantage of a recent change in the company's credit policy. The company had received a number of complaints from their customers, stating they were not doing as much business with the company as they could because of its relatively restrictive credit policy. Following a loosening of this policy, the CFO wanted to know if the company's bad debt percentage had risen dramatically and how the company compared to its industry peers.
She asked the company's benchmarking team to procure a global benchmark study, so she could understand the relative performance of the team. The benchmarking group determined top quarter performance was 7.0% of credit sales. Company ABC's information below was found by the team:
|Prior Credit Policy||Current Credit Policy|
|Total Credit Sales||$86,192,640||$99,072,000|
|Bad Debt Percentage||6.50%||6.80%|
While the company attributed much of the growth in credit sales to the new policy, the CFO was pleased to see a relatively small increase in bad debt over the same timeframe. Even more encouraging was the bad debt percentage was still bellow first quartile performance of 7.0%.