A bad debt reserve is a way to create a bank of funds to offset accumulated bad debt, which occurs when customer invoices remain unpaid. It can be used in receivable factoring, to write off bad debt due to bankruptcy, and to guard against bad debt incidence for small businesses.
As a means of minimizing the impact of bad debt on the functioning of a business, the bad debt reserve is simply a means of creating a bank of reserve funds that help offset accumulated bad debt. Typically, this bad debt occurs when customer invoices remain unpaid and there is not much chance of collecting outstanding invoices. Here are a few different scenarios where a bad debt reserve can have a positive impact.
One of the most common applications of a bad debt reserve is found in the receivable factoring business for a corporation. Essentially, a factoring company purchases a bank of invoices from a company, with the understanding that payments will be routed to the new owner of the invoices. The factoring company advances the customer a large percentage of the face value of the invoices, but keeps a percentage to be allocated in case of bad debts. The retained percentage is often calculated based on the average payment patterns that have been exhibited in previous billing periods involving the same customers. Once all outstanding invoices for the period have been paid and cleared, the reserved funds to cover bad debts are released and forwarded to the factoring company’s client.
Another example of the use of a bad debt reserve has to do with writing off bad debt due to a customer’s bankruptcy or bankruptcy. Even when a company files for bankruptcy protection and an agreement is reached to allow creditors to receive a small percentage of the debt owed, there is usually a substantial amount of outstanding invoices that the seller must clear. A bad debt reserve helps ease the trauma of having to commit to writing off outstanding bills as uncollected. Additionally, the action of using a bad debt reserve to cover these types of losses can also often be used as a deduction on annual tax returns, which helps further ease the financial loss for the business.
Even a small business may occasionally have a customer who is unable to honor an invoice for one reason or another. Having a bad debt reserve can be especially important for small businesses, as a large percentage of the revenue they generate tends to go towards core operations. When the revenue collected is much less than the generated value of the invoices, a source of funds to make up the difference becomes crucial. Building a bad debt reserve that is approximately equal to at least thirty days of operating expenses is an excellent way to guard against bad debt incidence and reduce the negative impact on the overall running of the business.
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