Reviewing Bad Debt Reserves: Protecting Your Company’s A/R Portfolio

The amount of money your business sets aside to account for financial uncertainty involves more than socking away spare change here and there. It can have a massive impact on your company’s future financial health. 

All businesses carry debt, but you’ll find differences in the types of debts that your business carries. While some people consider “debt” to be a negative in any connotation, businesses can hold both good debt and bad debt. Bad debt can lead to issues down the road, such as a negative impact on your credit score or problems with cash flow. Good debt, on the other hand, can have the exact opposite impact. A low-interest rate loan from a reputable lender that you pay off regularly, for example, could be looked at favorably: your business is seen as responsible and you can be trusted with additional credit. 

In essence, a bad debt reserve is a dollar amount of receivables that your company isn’t expecting to collect. This could be due to any number of reasons – international conflicts, bankruptcy or legal filings against customer businesses, to name a few. The key to calculating bad debt reserves is to estimate the amount as close to reality as possible. Overestimating a bad debt reserve could potentially make your company seem as though its cash flow is hindered or limited, which could have a knock-on effect when it comes to expanding your business through loans or new vendor relationships. If you use your Accounts Receivable as collateral for a loan, for example, overestimating your bad debt reserves will negatively impact your borrowing power.  

Bad debt reserves help you determine your cash flow needs. For example, if your bad debt reserve calculation shows you can expect a higher percentage of uncollectable debts in a certain quarter, you can then divert or raise capital as required to keep your business looking good. 

As of 2023, bad debt reserves have officially become a Generally Accepted Accounting Principles (GAAP) requirement, meaning all major companies should be consistently estimating their bad debt as part of their balance sheets to accurately predict potential risks to cash flow. This is also known as Current Expected Credit Losses, or CECL. 

Ultimately, the goal of bad debt reserves is to protect your company from risk. If your business has sufficient bad debt reserves built into your A/R or credit risk review process, then you won’t be caught off guard if your customer fails to pay or decides to file for bankruptcy protection. You’ll be able to take steps to not ship any more product to that particular customer on credit, or negotiate a monthly payment plan to help your customer pay off their debt while still protecting your business.  

Take the following example: Your company currently has $500,000 in receivables. But during routine monitoring of your customers, you notice that one of your customers with a $20,000 monthly invoice has been paying you more than 28 days late over the last 12 months. If you reserve for a full year’s worth of sales, you’d need to reserve $240,000. If you lower your customer’s credit line after reviewing their business credit score and only allow them to have one open invoice before approving their next order, you can limit your exposure. In that case, you could reserve $20,000 instead of $240,000 because only one invoice should be at risk at a time.  

According to our recent study, 68% of businesses have increased their bad debt reserves by up to 30% in the last 12 months. While this can be partially attributed to CECL methodologies becoming a requirement for most businesses, the dramatic rise in the amount of money companies need to set aside for bad debt points to complicated macro-economic stress factors and industry specific trends that impact slow payment habits. Around the world, corporate debt is increasing. This is something our study found, with over half (58%) of businesses saying their long-term debt has increased in the last 12 months. And if that wasn’t stressful enough for many businesses, an additional 74% also reported seeing their operating expenses increase in the last 12 months.  

While nearly every company operating in the US will already have a bad debt reserve, not all of them use them to their full advantage. It’s not always enough to simply perform the calculations once a year and reach a number or percentage of A/R you should reserve. Reviewing the figure on a regular basis lets you better analyze the trends in your A/R portfolio.  

Looking at the trends in your bad debt reserve figures can reveal a lot about your business and what you could be doing to strengthen it – and protect your cash flow down the line. 

Keep track of the changes in your bad debt reserve over time. You might notice one of the following, each with its own course of action to further protect your business.

If you notice your bad debt reserves are rising regularly, it could be a sign your credit processes aren’t keeping up with changes in your customers’ payment behaviors.  Your bad debt estimation is higher than your actual bad debt. While that may be considered a good thing – after all, you’ve ended up receiving the money that you had written off as no good – this can raise questions from your bank if you’re using your A/R portfolio as collateral, or potentially cause issues with internal or external auditors.

Let’s think about a few key areas you and your team should be considering when you think about bad debt reserves.  

Since most CECL methodologies require you to look back on your own data, a deeper dive into your company’s history with bad debt is never a bad idea. You might discover a trend that will help you inform your bad debt policy in the future. For example, let’s say that two years ago, you were doing a lot of business in a part of the country that’s since been devastated by forest fires. Businesses were closed for months and couldn’t pay their bills – some even shuttered completely. However, that was a once-in-20-years type of event. It wouldn’t be useful to factor it into your CECL calculation. Instead, you might consider reserving a small percentage of the A/R in that area to allow for similar unforeseen events.  

Nearly half (49%) of businesses admit they don’t use credit risk software to run business credit checks on new customers. Even the most detail-oriented credit manager can make mistakes. A good credit decisioning software can help reduce or even eliminate those mistakes by reducing the potential for human error. Automated credit decisioning speeds up your onboarding process and better protects your business from accidentally extending credit to someone likely to pay invoices late.  

Once you get to know a customer, usually over the course of a business relationship that lasts years or even decades, you have a much better idea of their payment behaviors. It’s easy to predict the payment patterns of a business you’re familiar with, but if you’re starting from scratch things can feel more up in the air. Look at your A/R portfolio and determine which outstanding invoices are from customers you have long-term relationships with and which are from newer customers. If most of your bad debt is coming from new customers, is there a problem you need to fix with your credit application process or the verticals your sales team is focusing on? Or, on the other hand, if most of your bad debt is from long-term relationships, have they become overly complacent, or is something impacting their ability to pay you on time?

The last few years have hit nearly every industry hard in different ways and we’re in the middle of an economic downturn. When you calculate your bad debt reserves, you might want to consider the fact that rising debt is impacting many – if not most – businesses around the world. It’s possible that a company that’s always been able to pay you back exactly on time is starting to lag in their repayments because of their financial situation. Accounting for the economy and events such as wars or natural disasters within your bad debt reserves will help decrease the risk of your bad debt reserve not fully covering your bad debts.