The true cost of Credit and bad debt

All businesses closely monitor costs. The aim is to reduce these as much as possible which will in turn help increase profit.

The below example shows a breakdown of the costs involved in taking credit from a supplier and offering credit to customers and includes a breakdown of costs involved if a business relies on a bank overdraft for example to cover this short fall in available cash possibly due to this been uncollected.

As an example the below table is an indication detailing the cost of credit for a company.

Cost of Credit No Credit 30 days 60 days 90 days
Annual sales £900,000 £900,000 £900,000 £900,000
Average Debtors (per month) Nil £75,000 £150,000 £225,000
Cost of credit as % of annual sales Nil 1% 2% 3%

The same calculation is used to work out the costs incurred for interest in a business with a high trade debt.

Sales ledger Balance  
100 (work out what 1% is)
365 (work out the amount per day)
X  
Rate of interest (e.g Bank overdraft rate)
X  
Number of days (days the cash is outstanding)

Using this calculation and at an interest rate of 12% we can work out that a Business with a monthly average Sales ledger balance of £100,000 will be paying approximately £986.00, every 30 days funds are outstanding.

If a business had a Sales ledger balance of £500,000, 90 days overdue, the cost in interest so far to cover would be approximately £14794.00.

If the business had this cash available, you have to ask yourself “How much is this worth?”

Not only is a business losing money due to the cost of interest and credit, it is possibly in a more vulnerable position.

For example

If a customer goes into liquidation any money owed is pretty much uncollectable. This is possibly more serious if a business supplies a product rather than a service as they not only lose money owed, but in most cases still have materials to pay for. This can in effect cost a business twice as much.

What does it costs in sales when we write off a debt?

Using the ANYCO example below

Write off Extra sales needed
£100 £1,136
£500 £5,680
£1,000 £11,360
£10,000 £113,600

Understanding the process

Opportunity cost

  • The amount a business pays, usually borrowings for working capital bank interest and charges. You could also include administration costs, i.e. staff chasing things up, possibly been given the run-around by a problem customer delaying things
  • The sooner the payment, the lower the opportunity cost - thus the lower the cost to the business
  • Remember your business has to pay its ongoing costs

Example - Anyco

  • ANYCO hires goods out for £50
  • Debt is £50
  • Gross profit margin is say 8.8%,Gross profit is £4.40
  • ANYCO opportunity cost is say 6% (Could be as much as 12% e.g Bank overdraft rate)
  • On £50, outstanding for 6 months, true cost of credit is £1.50
  • Deduct from profit of £4.40. Reduces profitability by 1/3rd
  • Even with large profit margins the cost of credit can swallow profits, taking into account slow payments bad debts and the opportunity cost
  • For every £50 not collected ANYCO have to generate £568 in sales

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