Bad Debt: A comprehensive guide

When long-overdue invoices from your B2B customers turn into bad debts, they don’t just disrupt cash flow. They can put your entire business at risk. These unpaid amounts create financial strain, making it harder to keep operations running smoothly.

Several factors contribute to bad debts, including economic instability that strains customers’ ability to pay, weak credit risk assessment when extending payment terms, inefficient collection processes and over-reliance on key clients who may unexpectedly face financial trouble.

Without a strong strategy to mitigate bad debts, your business risks serious liquidity challenges that can jeopardize your day-to-day operations. When bad debts pile up, your business may struggle to pay employees, cover rent or meet supplier obligations. Worse yet, a high level of bad debt can erode your business’s profitability, weaken its financial health and make securing financing for growth even more difficult. 

What are bad debts and where do they come from?

Bad debts arise when customers fail to pay invoices, due to financial troubles or poor cash management. Companies often extend credit to business customers, allowing them to defer payments. But if those payments are delayed or never made, cash reserves shrink, putting operations at risk. Businesses often have to set aside a bad debt provision to account for potential losses, but when an overdue invoice becomes a write-off (because it is uncollectible, it becomes a bad debt expense that directly impacts profitability.

Understanding the causes of invoice write-offs

Bad debt can disrupt your cash flow and lead to financial instability. Understanding the causes of invoice write offs is key to mitigating risks and safeguarding your finances.

Poor credit assessment is a primary cause. Extending credit without thoroughly evaluating a customer’s creditworthiness increases the risk of non-payment. Inadequate credit checks can result in engaging with clients who may struggle to meet their financial obligations, leading to bad debt.

Economic downturns also contribute to bad debt. During uncertain economic times, businesses may face increased competition and decreased consumer spending, leading to higher default rates. Failing to anticipate these shifts can result in more bad debt.

Inefficient collection processes, such as delays in follow-ups and inconsistent efforts, can lead to accumulating unpaid invoices and bad debt. Without clear protocols and prompt action, businesses risk losing control over overdue payments. Streamlining collections with automated reminders and structured payment terms can help reduce bad debt and protect cash flow.

Customer insolvency is another critical cause. When a customer becomes insolvent, they can’t fulfil their financial commitments, leaving you with unpaid invoices. This can arise from poor financial management, unexpected expenses or changing market conditions. Recognizing signs of potential insolvency can help prevent bad debt.

The true cost of writing off bad debts 

Imagine if most of your B2B sales on credit were affected by worsening payment behaviour from your business customers. This kind of disruption in cash flow can force your business to rely heavily on external financing sources, which in turn adds financial strain. If unpaid invoices eventually turn into bad debt write-offs, they represent direct financial losses, which make it harder for the business to maintain a stable cash position.

Beyond just lost revenue, bad debts can have a much greater impact on your bottom line. An unpaid invoice doesn't simply vanish - it means you need to generate significantly more business to make up for the loss. For instance, with an unpaid invoice of €10,000 and a sales margin of 12.5%, you would need to generate €80,000 (800% more turnover) just to break even. This emphasizes the importance of effective credit management to protect your business’s financial health.

Managing and mitigating bad debt for stronger cash flow

To stay financially secure, it is key to take control of bad debts, before they take control of your business.

Here’s how:

• Implement robust credit policies: Establishing strict credit policies can help reduce the risk of bad debts. Conduct thorough credit checks on new customers and set appropriate credit limits to minimize exposure to potential bad debts.

• Regular monitoring and follow-up: Regularly review your accounts receivable and follow up on overdue payments. Early identification of potential bad debts allows you to take proactive measures to recover the amounts owed.

• Foster strong customer relationships: Maintaining good relationships with your customers can improve the likelihood of timely payments. Clear communication and promptly addressing any disputes can prevent debts from becoming uncollectible.

• Utilise debt collection agencies: If internal efforts fail, hiring professional debt collection agencies can be an effective way to recover outstanding debts. These agencies have the expertise and resources to manage difficult collections efficiently.    

• Deploy specific risk mitigation tools: Instruments like letters of credit or retention of title can help reduce exposure to customer credit risk in certain situations. However, they may still leave businesses vulnerable to financial losses if payment defaults occur beyond their scope of protection.

• Leverage credit insurance: Credit insurance can provide protection against bad debts by covering a portion of the losses incurred from uncollectible accounts. This can be a valuable tool for managing risk and ensuring financial stability, allowing you to focus on growing your business without the constant worry of potential bad debts.

Mitigating the risk of write-offs with credit insurance

Unlike specific risk mitigation tools, credit insurance helps mitigate risk by shifting customer payment risks to a credit insurer, such as Atradius. By transferring this risk to a third party, your business not only gains financial security through coverage of losses from customer defaults or insolvencies, but also gains access to valuable complementary services, including business intelligence, risk monitoring, and debt collection support. This outsourcing strategy provides your company with a reliable safety net, allowing you to focus on core operations and confidently pursue growth strategies.

How we can help protect your business

Bad debts aren’t just an accounting issue; they are a direct threat to your company’s financial stability. Strengthening credit policies, improving collections, and optimising working capital aren’t just best practices; they are essential steps to safeguard your business. Don’t wait until an unpaid invoice becomes a major financial setback—protect your business from the dangers of defaulted payments and bad debts and ensure long-term growth with Atradisu credit insurance you can rely on.
 

Get in touch today to explore our tailored solutions that protect your cash flow and keep you on track for continued growth.