How to Calculate Bad Debt Percentage for a Business

Bad debt represents a financial loss a business incurs when customers fail to pay amounts owed for goods or services delivered on credit. These uncollectible amounts, known as accounts receivable, are a concern for businesses extending credit. Estimating bad debt is a fundamental accounting practice that influences a company’s financial health.

The impact of bad debt extends across financial statements, affecting profitability and asset valuation. Uncollectible accounts receivable reduce a company’s reported net income. This estimation process ensures financial statements present a realistic picture of a company’s assets and earnings, reflecting only amounts genuinely expected to be collected. Accurate bad debt estimation is crucial for informed business decisions.

Essential Data for Bad Debt Estimation

Estimating bad debt accurately requires gathering specific financial information. A foundational element is comprehensive historical credit sales data, spanning one to three years. These records provide context to identify past trends in customer payment behavior and the proportion of sales that become uncollectible.

Up-to-date accounts receivable reports are equally important. These reports, often from accounting software, should list each customer, invoice date, amount owed, and how long the balance has been outstanding. Regularly reconciling these ledgers ensures data is current and reflects actual outstanding amounts.

Businesses must also track historical bad debt write-offs, recording amounts and fiscal periods when debts were formally recognized as uncollectible. This historical record forms the basis for determining a business’s typical rate of uncollectible accounts.

Understanding a business’s credit policies and collection efforts further refines data collection. Terms offered to customers, such as net 30 or net 60 payment schedules, influence the aging of receivables. Information regarding collection activities, including reminder calls or demand letters, provides insights into the likelihood of collecting outstanding balances.

Applying the Percentage of Sales Method

The percentage of sales method estimates bad debt based on a predetermined percentage of a business’s credit sales for a specific period. This approach assumes a consistent relationship between credit sales volume and uncollectible accounts. It is often favored for its simplicity.

To determine the percentage, businesses review historical financial records. This involves dividing total actual bad debt write-offs by total credit sales over the same timeframe. For example, if a business had $50,000 in bad debt write-offs over three years from $5,000,000 in credit sales, the historical bad debt percentage would be 1% ($50,000 / $5,000,000). This historical rate serves as the basis for future estimations.

Once established, applying the bad debt percentage to current period credit sales is direct. If a business recorded $100,000 in credit sales for the current month and uses a 1% bad debt percentage, the estimated bad debt expense would be $1,000 ($100,000 0.01). This amount is recognized in accounting records to match expenses with revenues.

The accounting entry involves a debit to “Bad Debt Expense” and a credit to “Allowance for Doubtful Accounts.” Bad Debt Expense appears on the income statement, reducing net income. Allowance for Doubtful Accounts is a contra-asset account on the balance sheet, reducing accounts receivable to their estimated collectible amount.

For instance, a manufacturing business reviewed five years of data. It recorded $7,500,000 in total credit sales and incurred $112,500 in actual bad debt write-offs. This yields a historical bad debt percentage of 1.5% ($112,500 / $7,500,000). In the current quarter, the business generates $600,000 in credit sales. Applying the 1.5% rate, the estimated bad debt expense for the quarter would be $9,000 ($600,000 0.015). This $9,000 would be debited to Bad Debt Expense and credited to Allowance for Doubtful Accounts.

Applying the Accounts Receivable Aging Method

The accounts receivable aging method estimates bad debt by evaluating the likelihood of collection for each outstanding customer balance based on its age. This approach recognizes that older receivables are less likely to be collected. It provides a more granular estimate than the percentage of sales method, as it directly assesses the collectibility of existing balances.

The first step involves creating an accounts receivable aging schedule. This categorizes outstanding balances into time brackets based on invoice date, such as 1-30 days past due, 31-60 days, 61-90 days, and over 90 days. Each customer’s balance is placed into the appropriate category, and the total for each bracket is calculated.

Next, estimated uncollectible percentages are assigned to each age bracket. These percentages are derived from a business’s historical collection experience, indicating the average proportion of receivables in each category that prove uncollectible. For example, a business might assign 2% to balances 1-30 days past due, 10% to 31-60 days, 25% to 61-90 days, and 50% or more to balances over 90 days.

To calculate the total estimated uncollectible accounts, the dollar amount in each age bracket is multiplied by its assigned uncollectible percentage. The results from each bracket are summed to arrive at the total estimated uncollectible accounts receivable. This sum represents the desired ending balance for the Allowance for Doubtful Accounts.

The accounting entry involves a debit to “Bad Debt Expense” and a credit to “Allowance for Doubtful Accounts.” This entry adjusts the “Allowance for Doubtful Accounts” to reach the calculated target balance. If the existing allowance balance is $2,000 and the aging schedule indicates a required balance of $7,000, the bad debt expense recorded would be $5,000 ($7,000 – $2,000), increasing the allowance to the desired level.

For illustration, a service company has aged accounts receivable: $50,000 (1-30 days past due), $20,000 (31-60 days), $10,000 (61-90 days), and $5,000 (over 90 days). The company assigns uncollectible percentages of 1% (1-30 days), 5% (31-60 days), 15% (61-90 days), and 40% (over 90 days). The estimated uncollectible amounts are: $500 ($50,000 0.01), $1,000 ($20,000 0.05), $1,500 ($10,000 0.15), and $2,000 ($5,000 0.40). Summing these yields a total estimated uncollectible amount of $5,000. If the Allowance for Doubtful Accounts currently has a $1,000 credit balance, the company would record a $4,000 bad debt expense ($5,000 target – $1,000 existing balance) to bring the allowance to the required $5,000.