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Bad Debts Are Good

March 28, 2003
By Jerry Osteryoung

"Advice is like snow -- the softer it falls, the longer it dwells upon, and the deeper it sinks into the mind."
-Samuel Taylor Coleridge

Bad debts are bad, right? Nope, bad debts are good! Before you think I have "lost it," let me explain.

Bad debts are recorded on the income statement to basically reflect the fact that some sales you have made are just not going to be paid. Why they are not going to be paid, is immaterial for this discussion. But the point is that bad debts are recorded on the income statement to reflect dollars that are just not going to be collected. What is important to understand is that there is a fundamental relationship between a sales increase and the relaxation of credit policy. You just cannot look at just bad debts; rather you must look at the difference between sales increase and any increase in bad debts. In essence, it is okay for bad debts to go up, if and only if, profits increase even more. The basic notion here is that by focusing only on bad debts, you miss the other side of the coin (profits). The relationship between advertising and sales is very similar in nature to the relationship between bad debts and sales in that the incurring of increased advertising expenses generate more in sales and profits.

For example, suppose a firm has $1,000,000 in sales with 1% in sales that are bad debts and a 10% net profit margin (after the bad debts) or a net income of $100,000. If the firm relaxes credit standards, sales will go up by $300,000. However, the bad debts will rise to 5% (including the 1% bad debts the firm usually incurs) of the new sales. The net profit margin falls to 6%, but profit goes up by $18,000 or an 18% increase in net profit. So by having bad debts go up from 1% to 5% the firm made more than $18,000 in new profits, which is a great tradeoff. Shown below is a table, which spells this out in further detail, and shows profits at the existing levels, increase in sales and then the total.

Minimizing bad debts just isn't the right policy. The correct policy is to maximize the profits regardless of what bad debts may be. However, once you have a bad debt or customer who is not paying, then you need to try your best to collect the money that is owed to you.

I have met with many entrepreneurs who thought they were doing a wonderful job, as their companies had no bad debts. However, this policy hindered their firms' growth and prosperity.

Bad debts should not be minimized. They must be evaluated in terms of sales and profits. Consider increasing your bad debts to a level where your profits are maximized.