Accounts receivable is one of the most crucial functions of a business. It ensures that the company physically collects the revenue it makes on paper and does so in a timely manner. Accountants rely on several performance indicators to track progress and facilitate a proactive response to potential problems. The bad debt to sales ratio is one such example.
Before calculating the ratio, managers also need to understand bad debt. Bad debt refers to any amount of money owed to a company that it does not expect to receive. The inability to collect payments happens for various reasons, such as a customer’s bankruptcy or a refusal to pay.
What Is the Bad Debt to Sales Ratio?
This ratio measures the amount of money a company has to write off as a bad debt expense compared to its net sales. In other words, it tells you what percentage of sales profit a company loses to unpaid invoices. A high ratio can indicate that a company’s credit and collections policies are too lax. It can also suggest that the company is having trouble collecting customer payments.
How To Calculate Bad Debt To Sales Ratio
Calculating this ratio requires checking your company records for bad debts and net sales. Calculating bad debt varies across companies and industries because accountants have different measures. For example, a company might decide that anything not paid after 90 days is bad debt. Meanwhile, another company might extend that to 120 days, based on seasonal fluctuations in its clients’ businesses.
Net sales are much easier to calculate. Take your company’s total revenue and subtract any returns, allowances, or discounts. Once you have these two figures, use the bad debt to sales ratio formula below:
Bad Debt Expense / Net Sales
Example of Bad Debt Expense to Net Sales Ratio
Let’s say Company XYZ has total revenue of $100,000. It also has a bad debt expense of $10,000 and net sales of $90,000. This would give Company XYZ a bad debt expense to net sales ratio of 11.1%. Here’s how we arrived at this figure:
$10,000 bad debt expense / $90,000 net sales = 11.1%
How To Improve the Bad Debt Expense to Sales Ratio
Lenders prefer bad debt to sales ratios under 0.4 or 40%. However, most companies prefer to have much lower numbers than this. Unless you have no bad debt, there is room to improve. Here are some ways to accomplish lower bad debt to sales ratios:
- Review your credit policies. Are you granting too much credit? Should you mandate a down payment for new customers? Would shorter terms work better for you? Do you always send your invoices out on time?
- Implement or improve collection procedures. Conduct periodical reviews of your procedures. Are they effective? What can you do to improve them? Could you benefit from outsourcing collections?
- Analyze your customers. Do some customers always pay late? Would it be beneficial to stop doing business with them? What business characteristics do late payers share? Could you offer incentives for early payment?
- Automate the collection process. Automation makes it easier to track payments, send reminders, and take other actions to improve collections. It can also save workers time they would otherwise spend on tedious tasks, such as manual ratio calculations.
Every business faces bad debt risks in one form or another. However, companies that regularly extend credit face higher risks than others. Gaviti streamlines invoicing these customers, tracking payments, monitoring AR performance, and following up with debtors. Schedule a demo to get started.
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FAQs
Lenders prefer bad debt to sales ratios under 0.4 or 40%. However, most companies prefer to have much lower numbers than this. Unless you have no bad debt, there is room to improve.
Is a debt ratio of 75% bad? ›
Interpreting the Debt Ratio
If the ratio is over 1, a company has more debt than assets. If the ratio is below 1, the company has more assets than debt. Broadly speaking, ratios of 60% (0.6) or more are considered high, while ratios of 40% (0.4) or less are considered low.
What is a bad debt to ratio? ›
Key takeaways
A good debt-to-income ratio is less than or equal to 36%. Any debt-to-income ratio above 43% is considered to be too much debt.
Is 60% debt ratio bad? ›
By calculating the ratio between your income and your debts, you get your “debt ratio.” This is something the banks are very interested in. A debt ratio below 30% is excellent. Above 40% is critical. Lenders could deny you a loan.
What is an acceptable bad debt percentage? ›
The ratio measures the money a company loses on its overall sales due to customer(s) not paying their dues. The average bad debt to sales value in 2022 was 0.16%. The companies with the best ratio (best performers) reported a value of 0.02% or lower.
What does a debt ratio of 70% mean? ›
High debt ratio: If the result is a big number (like 0.7 or 70%), it means the company owes a lot compared to what it owns. This could be risky. Conversely, a higher debt ratio may raise concerns about ability to meet debt obligations and financial risks.
What does a debt ratio of 80% mean? ›
What if the debt ratio was much higher, like 0.8, or 80%? A debt ratio this high would throw up a red flag to the bank. At this level, the company would appear to have most of their assets funded by debt and would be a high risk for the bank.
What is a good bad debt to sales ratio? ›
Lenders prefer bad debt to sales ratios under 0.4 or 40%. However, most companies prefer to have much lower numbers than this. Unless you have no bad debt, there is room to improve.
What is a good DTI ratio? ›
As a general guideline, 43% is the highest DTI ratio a borrower can have and still get qualified for a mortgage. Ideally, lenders prefer a debt-to-income ratio lower than 36%, with no more than 28%-35% of that debt going towards servicing a mortgage. 1 The maximum DTI ratio varies from lender to lender.
How to calculate bad debt ratio? ›
Calculating the percentage of bad debt
Divide the amount of bad debt by the total accounts receivable for a period, and multiply by 100.
50% or more: Take Action - You may have limited funds to save or spend. With more than half your income going toward debt payments, you may not have much money left to save, spend, or handle unforeseen expenses.
How to tell if debt ratio is good? ›
From a pure risk perspective, debt ratios of 0.4 or lower are considered better, while a debt ratio of 0.6 or higher makes it more difficult to borrow money. While a low debt ratio suggests greater creditworthiness, there is also risk associated with a company carrying too little debt.
What is the debt to sales ratio? ›
Debt to sales ratio is a financial ratio that measures a company's ability to generate revenue to cover its debt payments. The ratio is calculated by dividing a company's total debt by its total sales.
What is a bad debt to worth ratio? ›
What is a bad debt-to-equity ratio? When the ratio is more around 5, 6 or 7, that's a much higher level of debt, and the bank will pay attention to that. “It doesn't mean the company has a problem, but you have to look at why their debt load is so high,” says Lemieux.
What is the bad debt to sales ratio for KPI? ›
Bad Debts to Sales Ratio
This KPI indicates bad debt, i.e., the percentage of credit sales that go uncollected. You can calculate your bad debt-to-sales ratio by dividing your company's uncollected sales by annual sales. Then you should multiply that number by 100.
What is the industry standard for bad debt rate? ›
Bad Debt Percentage Benchmark
The industry standard benchmark for Bad Debt Percentage is typically around 2-3% of net patient revenue. This means that for every $100 in net patient revenue, a healthcare organization should aim to write off no more than $2-$3 as bad debt.
What does a 75 debt-to-equity ratio mean? ›
A debt-to-equity ratio of 1.0 means that for every dollar of equity a company has, it uses $1 of debt to run the business. A debt-to-equity ratio of 2.0 means that for every $1 of equity a company has, it taps into $2 of financing. A debt-to-equity ratio of 0.75 equates to 75 cents borrowed for every $1 of equity.
Is 70 debt-to-equity ratio good? ›
For example, if a property is purchased with $1,000,000 in debt and $500,000 in equity, the debt to equity ratio is 2:1. Generally, a good ratio is 70% debt and 30% equity or 2.33:1, but this may vary depending on the type of property involved.
Can debt ratio be over 100? ›
Key Takeaways
A debt ratio of greater than 1.0 or 100% means a company has more debt than assets while a debt ratio of less than 100% indicates that a company has more assets than debt.
What does a debt ratio of 0.75 mean? ›
It is discovered that the total assets number $124,000 while the liabilities are at $93,000. The debt ratio for the startup would be calculated as. $93,000/$126,000 = 0.75. That means the debt ratio is 0.75, which is highly risky. It indicates for every four assets; there are three liabilities.
