A bad debt reserve is a way to offset accumulated bad debt caused by unpaid customer invoices. It can be used in scenarios such as factoring, bankruptcy, and small businesses to minimize the negative impact on the company’s functionality.
As a way of minimizing the impact of bad debt on a company’s functionality, the bad debt reserve is simply a means of creating a bank of reserve funds that helps offset accumulated bad debt. Typically, this bad debt is incurred when customer invoices remain unpaid and there is not much chance of collection on outstanding invoices. Here are a few different scenarios where a bad debt reserve can make a positive impact.
One of the most common applications of a bad debt reserve is found in the business of factoring a company’s accounts receivable. Essentially, a factoring company buys a bank of invoices from a corporation, with the understanding that payments will go to the new owner of the invoices. The factoring company advances a large percentage of the face value of the invoices to the customer, but retains a percentage to be set aside in case of default. The retained percentage is generally calculated based on the average payment patterns displayed by previous billing periods involving the same customers. After all outstanding invoices for the period are paid and released, the funds that were set aside to cover bad debt expenses are released and forwarded to the factoring company’s customer.
Another example of using a bad debt reserve has to do with writing off debt incurred due to bankruptcy or a customer going out of business. Even when a company files for bankruptcy protection and an agreement is reached to allow creditors to collect a small percentage of the outstanding debt, there is usually a considerable amount of outstanding invoices that the supplier must write off. A bad debt reserve helps alleviate the trauma of having to commit to writing off outstanding invoices when not collected. Furthermore, the action of using a bad debt reserve to cover this type of loss can also often be used as a deduction from annual tax returns, which helps to further ease the financial loss for the company.
Even a small business can occasionally have a customer unable to honor an invoice for one reason or another. Having a bad debt buffer can be particularly important for small businesses, as a large percentage of the revenue generated tends to go into core operations. When the revenue collected is much lower than the amount generated from the invoices, a source of funds to compensate for the difference becomes crucial. Creating a bad debt reserve that is approximately equal to at least thirty days of operating expenses is an excellent way to protect against bad debt incidence and lessen the negative impact on the overall running of the business.
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