This guide to bad debt covers how companies can minimise the risk of bad debt, recover debts from customers, as well as how and when a company can write off bad debt.
What is a bad debt?
Bad debt is debt owed by a customer that cannot be recovered. Often, bad debt is caused by the customer being declared bankrupt or becoming insolvent. However, bad debt can also be caused by a change in a customer’s personal circumstances resulting in a restriction in their cash flow.
How can companies manage bad debt?
Most companies extend credit to their customers (and in doing so become creditors). For a small business, writing off bad debt can have a huge impact on cash flow. Avoiding bad debt is, understandably, a key concern for both small and large businesses.
Businesses should take proactive steps to reduce their risk of incurring bad debt and manage any bad debt they take on to reduce disruption to their cash flow.
This guide explains how companies may avoid, and manage, bad debt.
How to manage and reduce bad debts
There are a range of steps companies can take to reduce the risk of bad debts occurring.
Create a well drafted business agreement with suppliers and clients
A professionally written, standard business agreement can help reduce the risk of taking on a bad debt. A written contract is formal evidence of the terms on which both parties mutually agree. Typically, the contract should cover how much the customer is to pay, when payment is due, any late payment penalties and procedures to follow should a dispute arise.
Where a contract refers to additional terms and conditions, it is essential that the contract explicitly states that it is to be read in conjunction with such terms. To help avoid a dispute, businesses should ensure that every customer is provided with a copy of their terms and conditions, and a chance to read and understand them, before signing the contract. For extra protection, businesses can ask their customers to acknowledge receipt of the terms and conditions in writing.
Implement an effective credit management system
Perhaps the most successful way in which to reduce to the risk of incurring bad debt is to ensure your business has an effective credit management system. An effective system should include some or all of the following processes:
- Credit checks on new customers and ongoing checks on existing customer
- Applications for company accounts from Companies House where necessary
- · Early issue of invoices with clear breakdowns of charges
- · Consideration of the usual payment habits of each customer and whether the business is in a position to adapt to them
- · Regular and pre-emptive reminders of the debt where appropriate
- · An effective complaints or queries procedure
- · Robust and consistent debt collection systems
A commercial law solicitor can help you put these measures in place.
Set credit limits for customers
Reduce the amount of bad debt your business is exposed to by setting and enforcing a maximum amount of credit offered to each customer. If you refer to the limit within the terms and conditions, the business can include a credit hold function for late payments. In turn, customers are encouraged to pay quicker in order to stay under their limit.
There is, of course, a balance to be considered in setting credit limits. The benefits of keeping bad debts to a minimum should not be outweighed by the detriment of restricting sales. Extending credit naturally generates some risk, but such risk can be reduced by the management of individual customers and attention to the position of their finances.
Late payment penalties
Late payment penalties act as an incentive for customers to pay on time. However, it is important to remember that oversights and genuine errors do occur. Imposing late payment penalties presents a real risk to a business relationship and, although the right to do so should be reserved in your terms of business, it should be considered whether this is in the best interests of the business on each occasion.
The Late Payment of Commercial Debts (Interest) Act 1998 grants businesses the right to claim interest at 8% above the Bank of England base rate from the day after the last date of payment being due. Where there is no specified agreement between the parties, this is assumed to be 30 days from the invoice.
Anticipate potential bad debt and ensure provisions are in place to help deal with the effects
Even where customers appear to maintain a healthy cash flow, there is an accepted level of risk in extending services on a credit basis. As such, provisions should be made to protect the business if the worst happens.
At the very least, some money should be set aside for use where payments are late and cash flow is tight. This sum should be increased with every “high risk” customer that credit is extended to.
It should also be considered whether credit insurance is necessary. Often, the cost of credit insurance is based on a small percentage of insured sales and/or business turn over. Numerous variables can affect the premium, such as trading history and historical debt loss, the trade sector and the company’s customer base.
Unavoidable bad debt may be tax deductible
Where debts are unrecoverable, it is vital to cash flow that no tax is paid on the income that is not received. A business can “write off” the tax on a bad debt as an expense on their profit and loss accounts, providing that:
- · The exact amount owed can be specified: it is not enough to estimate the possible short fall within the next year, debts must be specific.
- · There is clear evidence of the debt being owed to the business: a written contract detailing payment terms and evidence of the service having been provided in line with those terms will be sufficient
- · Reasonable efforts have be made to recover the debt: for small debts this will extend to a few phone calls and a follow up letter or email. However, for larger debts, more official channels should be explored such as debt collection agencies or solicitors. Written records evidencing the efforts made must be kept.
· Using debt collection agencies or small claims court to recover bad debts
Once reasonable efforts have been made to chase the debt, it may be more cost effective to outsource to a debt collection agency. Agencies usually charge between 5% and 15% of recovered funds and tend to have a high success rate.
Alternatively, recovering a debt less than £10,000 through the small claims court is a relatively straight forward process which can be done online. There is a fixed fee dependent on the debt owed, however as long as there is evidence of the debt being due the court will order payment.
Involving a debt collection agency and/or the small claims court will naturally damage the existing business relationship. Often, contracts will insist that parties attempt to engage in a mediation process so as to cause as little disruption to the relationship as possible.
Another aspect to consider is whether the customer has the funds to pay. It is no use obtaining a Judgment from the court if you know it cannot be enforced.
How to recover bad debts over £10,000
If your debt is over £10,000 it is not suitable for the small claims court and you should take professional legal advice.
Often, a strongly-worded letter from a solicitor is all that is necessary to ensure recovery of a debt. If you need to go to Court, it is always advisable to have a professional at hand to assist with the process.
Call our specialist Disputes solicitors on 0800 013 1165 for an initial chat, at no obligation, or fill out our enquiry form and a solicitor will get in touch.