Bad Debt

Bad debt is the portion of receivables the company will never collect: the customer is insolvent, has vanished, or the cost of pursuit exceeds any plausible recovery. Under accrual accounting, US companies recognize bad debt through an allowance: an estimate of expected uncollectible amounts is expensed as sales occur (under ASC 326, the current expected credit loss model, expected lifetime losses are estimated up front), and specific accounts are later written off against that allowance when they are deemed uncollectible.

For credit managers, bad debt expense as a percentage of credit sales is the ultimate loss metric, but it must be read alongside sales opportunity. A bad debt ratio of zero is not a triumph; it usually means the credit policy is turning away profitable marginal business. The optimal ratio is the one where the margin earned on the riskiest accepted customers exceeds the losses they generate. Typical B2B ratios run in the 0.1 to 0.5 percent of sales range, varying widely by industry and cycle.

The economics of bad debt are unforgiving because losses come out of margin, not revenue. A company earning 8 percent pre-tax margin must generate $1.25 million of new sales to recover the profit destroyed by a $100,000 write-off. That arithmetic, replacement sales equal to the loss divided by the margin, is the most effective sentence a credit manager can deploy when the organization treats credit losses as a routine cost of doing business.