There are hidden catches that you might want to consider before deciding to write off every problem account.
You have taken the measures: monitoring the credit ratings and reputation of your financial counterparties, setting up contractual netting agreements and ISDA agreements, revising the credit limits under certain market circumstances. Yet they do not rule out the possibility that your debtors would fail to meet their payment obligations.
When faced with such problem accounts, you have mainly two options:
- Keep the accounts open on the books until they are collected, or they are proved to be uncollectible
- Write off the accounts
The first option means continuing chasing the past due invoices, knowing that they inflate your trade accounts receivable and force days sales outstanding (DSO) up. The second option means putting an (impermanent) end to the ordeal of collection and keeping your accounts receivable clean.
With the majority of businesses deeming payment collections and handling recalcitrant debtors the most arduous tasks of credit management, it is no surprise that the second option is favoured. However, there are hidden catches that you might want to consider before deciding to write off every problem account.
1. You lose more than the written off amounts
Write-offs ÷ Net profit margin = Additional sales needed to offset the write-offs
Once you write off an account, it has a ripple effect on your entire business. It is not just the balance that is written off, it is the time of the marketing staff getting the deal, the time of the sales staff closing the deal, the time of the accounting staff recording the account, and the time of the collection staff chasing the payment.
Moreover, many businesses overlook the fact that many times, the cost of bad debts exceeds the written off accounts. Its impact is twofold: hurting the bottom line with the loss of the monies that you are owed, and restraining the growth of the top line.
For example, you write off four small past due trade receivables with a total balance of $2,000 and your business has a net profit margin of 5%. To estimate how much sales your business would need to compensate for the bad debts, divide your net profit margin by your write-offs.
Write-offs ÷ Net profit margin = Additional sales needed to offset the write-offs
In this example, writing off results in your business losing $2,000 and, at the same time, having to make $40,000 more in sales in order to recover from the loss of profit on the $2,000 write-offs.
This is why bad debt expense does not only have to do with the defaulted amount, but it also has a detrimental impact on your cash flow and impedes the profitability of your business.
2. You accumulate credit risk
Behind every written off balance is a decision to extend credit.
Usually small accounts are written off because their value does not justify the resources required to collect them. However, their volume is often so substantial that the cumulated balance could exert mounting pressure on your working capital. Given that no business is immune to bad debt, the strain keeps increasing as time goes on. The risk is notably high in emerging markets such as China and India, where multinationals typically establish local operating subsidiaries.
Nonetheless, most do not realise what is at stake since it is common for written-off accounts to fade into oblivion – out of sight, out of mind. When they are not open on the aging, there is little incentive to assess the situation or to seek alternative collection solutions. What you may end up doing is practically granting the debtors financing for free.
It should also be taken into account that behind every written off balance is a decision to extend credit. By leaving the problem accounts on the accounts receivable, it is apparent that the rest of the aging could make more use of risk mitigation measures.
Without a commitment to reduce write-offs, the credit risk lurking in everyone’s blind spot is likely to develop to be far greater than expected when it materialises.
3. You deviate from good stewardship of trade receivables
Many write-offs equal a large amount of bad debt expense, which would eventually show up on financial statements and come under close scrutiny. To soften the blow, only parts of the write-offs make their way to the reports in most cases.
Considering that bad debt expense is probably the most important non-cash expense in a financial report, the lack of congruity can produce two adverse effects. The immediate effect is misstatements in reporting due to the accounts receivable being exaggerated. The later effect is an increase in write-offs including accounts that could still be collected – for it is an easier option and there are no consequences of writing off frequently in the first place.
As a result, writing off becomes the preferred choice whenever the circumstances allow it. This consequently raises the written-off balances, which would not be fully presented in financial reporting because of their large number. In this way, the vicious circle repeats itself. Such outcomes could prove seriously damaging, especially to multinationals where it is possible for more than one local operating entity to abandon effective financial controls and governance.
'Write off and move on’ does not hold true when you look at its full impact
Making extra collection endeavours might seem less enticing, yet both the workload and resources required are commonly found to be below what it takes to compensate for the writing off of the same balances.
Although write-offs cannot be avoided entirely, all means should be exhausted before any past due trade receivables are judged as uncollectible. From ageing analysis to persistently tracking each unpaid invoice, your team can make sure that no due receivables can slip through.
If the debtors keep being unresponsive to your collection attempts, it may be time to seek support from a third party. There are some advantages they can supplement your team with. The most important gain is your time and resources.
Once an external collection specialist takes over the problem accounts, you can channel your team’s attention into the new and current receivables. Next to that, your chance of collections improves significantly. Major collection agencies often bring years of experience and specialised approaches to the table. Combined with your knowledge of the debtors, collection approaches from an external party carry much more weight in many cases; because the debtors interpret a third party’s involvement as your escalation of the matter.
Another benefit is that your financial reporting is enhanced. Good collection agencies always document their collection efforts and interactions with the debtors. The information does not only enrich your reports, but also helps maintain reporting standards across all local operating subsidiaries.
Last but not least, your compliance is guaranteed. International collection agencies like Atradius Collections have an extended network of local law firms that ensure every collection activity complies with the regulations of the country where it is performed.
Compared to writing off, making extra collection endeavours to recover past due trade receivables might seem less enticing. Yet, both the workload and resources required for this are commonly found to be below what it takes to compensate for the writing off of the same balances.
At the same time, by taking measures to mitigate writing off and save it as the last resort only, you have also minimised its risks and saved both the top and bottom line of your business.