Welcome to Your Study Guide on Commercial Risks: Bad Debts
Hello future business leader! This chapter is all about one of the most common and worrying risks faced by businesses: the risk that customers won't pay their bills. Don't worry if this sounds scary—we are going to break down the concept of Bad Debts so you understand exactly what they are, why they happen, and how smart businesses manage this risk.
Understanding bad debts is crucial because it directly impacts a company's profit and its ability to pay its own bills (cash flow). Let’s dive in!
Section 1: The Basics – Selling on Credit and Creating Risk
1.1 What are Credit Sales?
In Commerce, a business often allows customers to buy goods or services now and pay for them later. This is called selling on credit.
- Example: A supermarket chain buys 1,000 loaves of bread from a bakery. The bakery gives the supermarket 30 days to pay the invoice.
When a business sells on credit, it creates a special relationship:
- The business is the Creditor (the one owed money).
- The customer who owes the money is called the Debtor.
Did You Know? Allowing credit sales is often necessary to attract large business customers and increase sales volume. However, it immediately introduces the risk of non-payment.
1.2 Defining a Bad Debt
A Bad Debt occurs when a debtor (customer) who owes the business money is unable, or unwilling, to pay the amount owed, and the business determines that the money will never be recovered.
When the business officially accepts that the money is lost, the debt is written off the books and becomes an expense, or a loss, known as a Bad Debt Expense.
Analogy: Think of lending a friend $50. If your friend loses their wallet and truthfully tells you they can never pay you back, you have to accept that $50 as a bad debt. It's a loss for you.
Key Takeaway: Bad debts are the direct financial loss incurred by a business when customers fail to pay for goods or services bought on credit.
Section 2: Bad Debts as a Major Commercial Risk
Bad debts fall squarely under the category of Commercial Risks because they result from regular trading activities. When a bad debt occurs, the consequences for the business can be severe.
2.1 Financial Impact of Bad Debts
The money lost isn't just the profit—it's the entire amount of the sale, including the original cost of the goods. This impacts the business in several ways:
- Loss of Profit: Since the revenue from the sale is never received, the intended profit is lost. The business must treat the bad debt as an expense, which reduces its overall net profit.
- Cash Flow Problems: This is often the most critical impact. Businesses rely on money owed by debtors to pay their own bills (wages, rent, suppliers). If several large debts go bad, the business may not have enough cash immediately available to operate, potentially leading to bankruptcy.
- Wasted Resources: Before deciding a debt is truly "bad," the business spends time, effort, and money trying to recover it (e.g., sending reminders, making phone calls, legal fees). These resources are wasted once the debt is written off.
Warning! Common Mistake to Avoid: A bad debt is not just a reduction in profit; it means the business has actually made a loss on that specific transaction, which then reduces the overall profit.
2.2 Reasons Why Debts Go Bad
Debts usually become uncollectable due to the financial situation of the debtor:
- The debtor goes bankrupt or closes their business down.
- The debtor faces unexpected financial difficulty (e.g., a major contract falls through).
- The debtor simply disappears or cannot be located.
- The customer disputes the quality of the goods and refuses to pay (though this often involves legal negotiation before being written off).
Key Takeaway: Bad debts threaten a business’s solvency (its ability to survive) by reducing profit and causing severe cash flow shortages.
Section 3: Minimizing the Risk of Bad Debts (Risk Management)
Since selling on credit is necessary in modern commerce, businesses must adopt strict policies to manage and minimise the likelihood of bad debts. This is effective risk management.
3.1 Steps Businesses Take to Assess Risk
Before offering credit to a new customer, successful businesses follow these steps:
A. Performing Credit Checks (Due Diligence)
The business investigates the financial history and reliability of the potential customer.
- They use credit rating agencies (companies that track payment history).
- They ask for references from other businesses that have dealt with the customer.
- They check the customer's financial statements (if they are a large company).
Simple Trick: If you are lending a textbook to someone, you want to know if they returned the last book they borrowed on time! A credit check is just a formal way of doing this for money.
B. Setting Credit Limits
A credit limit is the maximum amount of money a business allows a specific debtor to owe at any one time. This limits the potential loss.
- A customer with a great payment history might have a high credit limit (£50,000).
- A new or slightly riskier customer might have a low credit limit (£5,000).
3.2 Steps Businesses Take to Encourage Payment
Once the sale is made, the business actively works to ensure prompt payment:
- Offering Cash Discounts: Businesses might offer a small percentage discount (e.g., 2% off) if the customer pays the invoice within a very short period (e.g., 10 days instead of 30). This strongly encourages quick payment.
- Issuing Clear Invoices and Statements: Making sure the customer knows exactly what they owe, and when it is due, minimizes confusion and delays.
- Debt Chasing (Follow-up): Sending polite reminders as soon as an invoice becomes overdue. This is a crucial administrative task.
- Using Collateral or Guarantees (In some industries): Requiring the debtor to provide security (like valuable assets) that the business can claim if the debt is not paid.
3.3 The Final Step: Debt Collection Agencies
If a debt remains unpaid for a long time despite repeated efforts, the business may use a Debt Collection Agency. These are specialised companies hired to recover the money, usually in exchange for a percentage of the amount collected.
Using a debt collection agency is expensive and can damage the relationship with the customer, but it is often better than losing 100% of the money.
Key Takeaway: Smart risk management involves thorough checks before offering credit and efficient payment recovery procedures after the sale.
Quick Review Box: Bad Debts Essentials
| Term | Definition | Impact on Business |
| Debtor | A customer who owes the business money for goods bought on credit. | The source of the risk. |
| Bad Debt | Money owed by a debtor that is deemed completely uncollectable (lost). | Reduces profit and creates cash flow shortages. |
| Risk Mitigation | Actions taken to reduce the risk of loss. | Involves Credit Checks, Setting Limits, and Offering Discounts. |
You have successfully mastered the concept of bad debts as a major commercial risk! By understanding why they happen and how businesses prevent them, you have taken a big step in understanding commercial management.