Working Capital

Metric of the Month: Uncollectable Balances as a Percentage of Revenue

It’s more important than ever to know how much bad debt your company holds.
Perry D. Wiggins, CPAAugust 4, 2020
Metric of the Month: Uncollectable Balances as a Percentage of Revenue

In a chaotic business environment hampered by a global pandemic, many vendors, suppliers, and other businesses are holding “bad debt” in the form of payments owed that will never be collected from customers. When does a finance chief know his or her company is holding too much bad debt, and what can be done about it? This month, we dig into uncollectable balances to explore how much leading companies hold relative to their revenue and explore the strategies they carry out to keep uncollectable balances as low as possible.

Through its Customer Credit and Invoicing Open Standards Benchmarking survey, APQC found that uncollectable balances represent 0.51% of revenue or less for top performers, while bottom performers see uncollectable balances of 0.88% of revenue or more. These percentages seem small at face value but add up quickly, especially for larger companies.

A bottom-performing company with a billion dollars in annual revenue, for example, risks nearly nine million dollars or more in uncollectable balances. Making improvements to fall among the median performers would mean this company could potentially save $2 million, or nearly $4 million if it can move to top-performer status. There’s a lot that even a large company could do with that $4 million, especially when some companies in today’s economic environment are struggling to keep the business above water or to continue making their payroll.

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Track the Warning Signs

Given the economic impacts of COVID-19, it is reasonable to expect that uncollectable balances will creep up across the board — particularly for companies that service industries that are hardest hit by the pandemic. Even so, there are at least three things you can do to ensure that uncollectable balances don’t spiral out of control.

First, while APQC frequently recommends that organizations benchmark their performance relative to their peers for a more holistic performance assessment, it’s also important to benchmark internally and track your company’s data over time. While it might be natural to see your uncollectable balances tick upward right now, the important question is: Do you know where you stand on this measure relative to where you were three months or a year ago? If your uncollectable balances were relatively low before COVID-19 but are significantly higher now, it may be a sign that you’re carrying bad debt.

As you internally track the trendline for this measure, you should also be paying attention to leading indicators like your revenue-to-cash ratio. Ideally, this ratio should be as close as possible to 1:1 — if a company reports $1 million in sales for one month, it should also bring in the same amount (or close to it) in cash in the subsequent period. If the subsequent period’s cash collections are 80% of the prior month’s reported revenue, ask yourself where that gap is coming from — today’s gap could very well signal tomorrow’s uncollectable balances.

A third way to stay on top of uncollectable balances is deceptively simple: Know your customers. A company that does will be well-positioned to know which customers are likely to have challenges paying right now. If your company sells restaurant supplies and equipment, provides component parts to aircraft manufacturers, or is financially tied into the hospitality industry, you should know what’s likely coming and be ready to extend terms, write off that bad debt, or tighten your credit policies.

Strategies for Bringing In Cash

If you find yourself among the bottom performers on this metric, the good news is that there are plenty of proactive, holistic strategies at your disposal, including:

  • Investing time and training in collections the right people with the right training will know how to stratify and prioritize accounts for collection, how to work with customers, and who might be worthy of extended payment terms.
  • Requiring a deposit upfront makes it more likely that the customer will pay the balance.
  • Leveraging credit holds until the customer pays the existing balance.
  • Early pay discounts, which incentivize the customer to pay faster.
  • Customer self-service portals, which accelerate the speed at which customers can research and resolve disputes or billing errors to bring money in more quickly.

While all of these strategies should be on the table, you should also think carefully about how flexible you’re willing to be for a customer. As I discussed in the May 2020 column on days sales outstanding, keeping a high-value customer might make it worth accepting slower or lower payment as you and your customer work through the economic hardships of the COVID-19 crisis. While you certainly shouldn’t sabotage your own bottom line, it may be worth agreeing to extended payment terms to maintain your most important and strategic customer relationships.

Uncollectable balances ultimately represent money you won’t be paid for a service or product you’ve already delivered. We should expect a larger portion of uncollectable balances for now, which means it’s more important than ever to monitor this measure, track the trends, and work with customers to recover what you can.

Perry D. Wiggins, CPA, is CFO, secretary, and treasurer for APQC, a nonprofit benchmarking and best practices research organization based in Houston.