When you want to land investors or determine where your company is headed, you need to navigate some treacherous financial waters. This requires a financial forecast, lest you be lost. But wait, what’s this? A storm lurks ahead! The clouds are blocking your view and you have no idea where you’re headed. The name of those clouds? Uncollectible accounts and bad debt. Argh, these be the nastiest of storms.
It’s an unfortunate truth in business that not all your clients will pay their bills. Unless you only deliver your product or service after payments are rendered, you’re likely to have a few clients that won’t pay what they owe. These uncollectible accounts have virtually zero chance of being paid off, making them bad debt through and through. Investors may not mind some debt, but bad debt? That’s a big no no.
So what’s a business owner to do? You can’t turn away all business out of fear. Like a looming storm, the best thing you can do is prepare for bad debt and uncollectible accounts. Using the percentage of sales method, you can do just this and determine what percentage or amount of bad debt needs to be built into your finances.
It’s time to learn how to maintain correct financial statements and accurately forecast revenue by accounting for these bad debts in your budget with the percentage of sales method. But first let’s look at what an allowance is. (No, not the kind your parents gave you.)
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What is an allowance and why does it matter?
Before you can begin tackling your percentage of sales and building accurate estimations for potential investors, you need to know what allowance needs to be set for doubtful accounts. This crucial part of financial forecasting allows you to predict how your company will do next year, as it’s easy to look at sales figures, like total sales, and think your company is making X amount. In reality, you could have numerous delinquent accounts and long-term debt impacting your actual cash flow.
So what exactly is an allowance when talking financial accounting? In this case, it’s a set amount that represents how much bad debt or how many doubtful accounts you predict you’ll have. Think of this as a buffer for predicted loss.
Allowance for doubtful accounts appears on your balance sheet right beneath your accounts receivable balance. It’s a contra-receivable account that reduces the value of your receivables and overall assets. Generally accepted accounting principles require that businesses maintain an allowance for bad debts. That means that estimating uncollectible accounts is a necessary task if you want to produce GAAP financial statements for potential or existing lenders and investors.
An allowance also gives you a better picture of what assets you will have at your disposal. When forecasting future cash flow, you’re better off erring on the side of caution and being realistic about how much you can actually collect, so keep this in mind when determining your own allowance for bad debt.
How to estimate your allowance
Before you start panicking and planning for a ton of debt, it’s important you know which method you should use to determine your allowance for bad debt. Each method is useful for different reasons, so read the following sections carefully to determine which one fits your ship the best.
Percentage of sales method
Allowance is an important part of financial forecasting, but the percentage of sales method is an even more integral part of knowing where you are in the short-term and long-term, and for luring in investors. Why? It helps you understand how much bad debt you currently have, and how much you’ll likely have in the future. This paints a more accurate picture of your company’s financial health — for your sake and the sake of investors.
In short, the percentage of sales method estimates the amount of bad debt expense a company will incur based on the amount of sales it makes on credit. For example, if a business made $100,000 worth of sales revenue on credit and estimates bad debt to be 2% of credit sales, it would add $2,000 to the allowance for doubtful accounts. When the company has to actually write off uncollectible accounts, those are written off against the allowance account.
With this information, you can then have a more accurate idea of how much you may accrue in bad debt next year as well. This information can be helpful when presenting to investors, predicting how much cash flow you’ll have the following year, and understanding how much actual owners’ equity you have. More than a quarter of all startups fail because of cash problems. Knowing how much debt to expect can help you avoid that and thrive as a small business owner.
Percentage of receivables method
Who doesn’t like having options? With the percentage of receivables method, you can find out how much allowance to set for doubtful accounts in a different manner.
Where the percentage of sales method looks at sales, the percentage of receivables method looks at the current amount of accounts receivable the business has accumulated at its point of calculation. The resulting figure indicates what the allowance for the doubtful accounts balance should be.
For example, say a company estimates that 1% of accumulated receivables are likely to be uncollectible and the receivables balance is $500,000. Under this method, the balance of the allowance for doubtful accounts should be $5,000. It’s worth noting that the balance used includes existing balances as well.
This means the receivables method includes previous year’s balances, including debt balances, giving you a more holistic view of your company’s bad debt. Unlike the percentage of sales method, which only looks at the current year’s bad debt, the percentage of receivables method looks at all your company’s bad debt. Barring any major shifts in the current year over last year, this can give you a more realistic idea of the bad debt you need to build in to your budget.
Specific identification method
The percentage of sales and percentage of receivables methods both work well if you receive a relatively small amount of revenue from a large number of clients. In other words, if you have a large number of clients that contribute to your total assets and revenue, the sales and receivables avenues are great allowance methods. This is common for enterprise software companies, or those dealing only with bulk products that go out to major distributors.
If you have a few major clients that comprise most or all of your revenue, you may want to specifically identify the chance of default for each one. This is due to the fact that a single client leaving could result in your business taking a massive hit, as that one client makes up a huge part of your income and greatly influences your sales forecast.
To get a full idea of a client’s likelihood of defaulting, you need a view of their credit score, as well as numerous other accounting angles that only a financial institution would have access to. While you may not have access to this information, there are a few things you can look out for to get an idea of whether things may be heading into default territory:
Shift in order size
If you have a customer who routinely orders a certain amount, and you find they’re suddenly ordering a substantially larger amount, this could be a sign that their business is going through a sudden growth spurt. Assuming you have a solid relationship, this can be a great time to comment that their business must be doing great and see how they react.
Contrarily, if your client suddenly starts ordering much lower amounts, this could also point to financial problems. As the supplier or business selling them a certain product, this is a great opportunity for you to ask why they’re lowering their typical order amount. It could be the company’s net income is plummeting, or perhaps they’ve found another supplier. (In which case, you can try to swoop in and save the deal.)
Failure to pay a recent invoice
This might seem like a giant “duh” point, but it should be a huge red flag if your bigger clients fail to pay a recent invoice. As a bigger client, this is a great chance for you to have an open dialogue about why they fell behind on payment.
Before you panic, hear them out. Maybe they have a new accounting person that simply forgot to pay you. Or they could be in financial trouble and on the brink of becoming bad debt. Either way, this issue absolutely warrants a discussion before you take further action.
Changes in behavior
If you have a great relationship with a certain client and suddenly find they’re not acting like they usually do, this could be a sign of treacherous seas ahead. Things like being late to sales calls, falling behind on payments, or seeming aggravated during talks should be red flags that something needs to be done and quick.
Recent complaints about older orders
If a client is suddenly complaining about the products or services from a previous invoice months after the fact, this is a big, bad sign that something else is really the root problem. Have you ever found yourself frustrated with your TV or internet provider, and promptly get on the phone to try and drive down the price? This is exactly what’s happening here.
It’s not an absolute science, but the above points can help you get an idea of whether or not there’s trouble in paradise with larger clients. (And smaller ones too.)
Determining a percentage for the estimate
There’s no standard percentage used to estimate bad debts in any of the formulas. When it comes to estimating uncollectible accounts, your past financial information is usually the best indicator of future activity.
Review your past financial statements and evaluate the relationship between bad debt write-offs, credit sales, and receivables balances. For example, if you made $300,000 in credit sales last year, and you wrote off a total of $3,000 in bad debt — and the amounts were relatively proportional in other years — it’s safe to assume that bad debt expense tends to be around 1% of credit sales.
Picking a percentage is trickier when you don’t have prior year data to rely on. When questioned on the topic, entrepreneur and angel investor Tim Berry, recommended that start-ups try to discover the percentage used by similar businesses. He suggests calling colleagues at a few businesses that are similar to yours but aren’t competitors — like companies in a different market or geographical location — and asking what figures they use.
Forecast: Bright and accurate
Financial forecasting can be anything but fun at times, but it’s a necessary part of running a business. It’s also a necessary part of attracting investors, as nobody will want to invest in a company with a murky present and even murkier future. Bad debts aren’t fun, but being honest and open about them will go a long way toward instilling confidence in those thinking about putting money into your company.
Now, small business captain, set sail toward a brighter, more accurate future as you navigate debt, cash flow problems, and maybe even the occasional kraken, like a total pro.
This article was produced by the QuickBooks Resource Center and syndicated by MediaFeed.org.
Featured Image Credit: iStock/BartekSzewczyk.