Write Offs Can Be Part Of A Profit Maximization Strategy
No one wants bad debt. Everyone hates it when you do not get paid. But, is it possible that never having had a bad debt is a sign of a problem? Absolutely!
Over the last few weeks, I’ve heard these comments from a few CFOs:
“Next to zero bad-debt write-offs and no disputed accounts in the past 5-years.”
“All of our customers pay in 60 days or less. We do not have seriously past due or disputed accounts.”
“Currently we do not have any uncollected accounts on our books. For the record, in the last 25 years we have had no bad debts.”
From one perspective, this is amazing and commendable. But, it does not necessarily mean it’s good. It is an indication that the finance staff does a bunch of things right, such as having solid credit applications, excellent credit review, appropriate terms & conditions documentation, accurate invoicing, prompt follow up on past due invoices and tenacity when problems arise.
If a company has no write-offs and never lost a sale due to their credit policy, then this truly is commendable. That is the real goal for the credit department. But, if the credit policy is so strict that sales are lost, never having a write-off is most likely a sign of a problem.
Increase Profits By Increasing Bad Debt Risk
Here is a simplified example: If your profit margin is 10%, then getting an extra million in revenue generates a $100,000 in profits. Even if you have some bad debt in this incremental million dollars of sales, as long as write-offs are less than the $100,000 in profits, your total profit will have increased.
We have many software and SAAS clients who clearly understand this. With marginal profit margins at 50% to 90%, they can afford a few write-offs as the actual out-of-pocket loss is minimal. Even if 20% of the risky accounts that get approved turn out to be bad, an extra $10 million in revenue results in $3 million to $7 million in increased marginal profit at these high margins.
Political And Strategic Considerations
No one wants to have to explain bad debts. KPIs such as DSO are negatively impacted by a looser credit policy. Having to repeatedly explain that the ‘bad news of a write-off’ actually is not bad is not something to look forward to.
There are other factors that need to be evaluated when considering relaxing credit standards. Company valuations are impacted by profit margins, revenue growth, and total profitability, so there are trade-offs that need to be managed. Choosing the right profit margin measure (gross margin, pre-tax margin, EBITDA margin. etc.) requires assessment. Predicting riskiness of relaxed credit standards is difficult. Or, your company may have limited sales or production resources and therefore credit policy is not the bottleneck that needs to be overcome.
If your business model allows you to get paid up front or to have tremendous leverage over your customer’s business, then never having bad debt is understandable. Otherwise, never having a write off is an indication that for some reason your company is not maximizing revenue and total profits. Instead of viewing “no bad debt” as a badge of honor, finance and credit professionals should see that as a signal of an issue that needs to be investigated and addressed.
When you do have an apparent bad debt, if you want a former CFO (with an MBA from a top 5 university) who has closed over $500 million in business transactions to collect your invoices, please contact me. We have an 85% success rate on large viable claims working on contingency with rates from 10% to 25%.
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