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
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.
What is a good sales to debt ratio? ›
A good DTI ratio is 36% or less. This means that your total monthly debts, including your mortgage payment, car payment, student loans, and credit card payments, should be no more than 36% of your gross monthly income.
What is a bad debt in sales? ›
What Is a Bad Debt Expense? A bad debt expense is recognized when a receivable is no longer collectible because a customer is unable to fulfill their obligation to pay an outstanding debt due to bankruptcy or other financial problems.
Is 0.7 a high debt ratio? ›
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.
Is 0.5 a good 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 good bad debt to sales ratio? ›
Lenders prefer bad debt to sales ratios under 0.4 or 40%.
Is 50% debt ratio bad? ›
The lower the debt ratio is, the better position they're in to handle the debt load. Not only does this mean a lower level of financial risk, it could also mean that the company is more financially stable. A comfortable debt ratio is below 0.50 or 50% but again, it all depends on what the industry average is.
What is a typical bad debt percentage? ›
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 is a good bad debt? ›
Good debt—mortgages, student loans, and business loans, steer you toward your goals. Bad debt—credit cards, predatory loans, and any loan used for a depreciating asset—steers you away from your goals. With debt, moderation is key; even good debt, when overused, can turn bad.
What is bad debts time ratio or sales ratio? ›
The bad debt 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.
35% or less: Looking Good - Relative to your income, your debt is at a manageable level. You most likely have money left over for saving or spending after you've paid your bills. Lenders generally view a lower DTI as favorable.
What is a too high debt ratio? ›
Key takeaways
Debt-to-income ratio is your monthly debt obligations compared to your gross monthly income (before taxes), expressed as a percentage. 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.
What should debt to ratio be? ›
Read our editorial guidelines here . Your debt-to-income (DTI) ratio is how much money you earn versus what you spend. It's calculated by dividing your monthly debts by your gross monthly income. Generally, it's a good idea to keep your DTI ratio below 43%, though 35% or less is considered “good.”
Is 0.8 a good debt ratio? ›
What counts as a good debt ratio will depend on the nature of the business and its industry. Generally speaking, a debt-to-equity or debt-to-assets ratio below 1.0 would be seen as relatively safe, whereas ratios of 2.0 or higher would be considered risky.
Is 5 a bad debt to equity ratio? ›
When it comes to debt-to-equity, you're looking for a low number. This is because total liabilities represents the numerator of the ratio. The more debt you have, the higher your ratio will be. A ratio of roughly 2 or 2.5 is considered good, but anything higher than that is considered unfavorable.
Is a debt ratio of 1 good? ›
Generally, a good debt ratio is around 1 to 1.5. However, the ideal debt ratio will vary depending on the industry, as some industries use more debt financing than others. Capital-intensive industries like the financial and manufacturing industries often have higher ratios that can be greater than 2.
What is a good revenue to debt ratio? ›
35% or less: Looking Good - Relative to your income, your debt is at a manageable level. You most likely have money left over for saving or spending after you've paid your bills. Lenders generally view a lower DTI as favorable.
What is ideal sales ratio? ›
For most growing e-commerce businesses, the right I/S ratio falls somewhere between 0.167 and 0.25. But a higher number could still be a healthy benchmark if you're scaling rapidly. It all depends on your industry, rate of growth, and any number of other variables.
Is a 6% debt-to-income ratio good? ›
Your debt-to-income (DTI) ratio is how much money you earn versus what you spend. It's calculated by dividing your monthly debts by your gross monthly income. Generally, it's a good idea to keep your DTI ratio below 43%, though 35% or less is considered “good.”
Is a 40% debt ratio good? ›
A debt ratio below 30% is excellent. Above 40% is critical.
