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The fine line between bad debt and an unpaid invoice

Posted: 15 Jan, 2019

An unfortunate part of business is the need to deal with customers who fail to pay on time, or who simply refuse to pay at all. In fact it is estimated that 42% of SMEs spend up to four hours each and every week chasing up late payments, representing a huge amount of wasted time which could be used much more effectively.

However, once an invoice becomes overdue, it needs to be a priority to chase this to prevent the debt turning bad. While there is often a fine line between an unpaid invoice and bad debt, the distinction between them is crucial.  An unpaid invoice is a debt which is yet to be paid; a bad debt is one which will never be paid and is therefore written off.

Bad debt or doubtful debt?

When dealing with a debtor who is not forthcoming in paying what they owe, the key is knowing whether a debt has turned bad or if payment is simply late. Certain things, such as your debtor entering liquidation, means you can quite comfortably assume that you are dealing with a bad debt. While there is a chance you may receive some money from the proceeds of the liquidation, if the company was insolvent and you were an unsecured creditor, then the chances of this are very slim.

Before an outstanding invoice is officially classed as bad debt, it may be referred to as ‘doubtful’ debt. While doubtful debt is unlikely to be recoverable, there is still a chance of realising something if the debtor company is still active and you have retained at least some form of contact with them. An unpaid invoice turns into a bad debt when you are left with no alternative but to write off any chance of recovering the money owed. This should only be done after all avenues for collection have been exhausted and your debtor has proved to be non-responsive.

Once a debt is deemed to be bad, this must be reflected in the company’s accounts by being removed from the accounts receivable balance. If you utilise the Standard VAT method then you may qualify for a rebate for any VAT associated with the transaction that has already been paid to HMRC.

Carrying bad debt and being forced to write off large sums of money can have devastating consequences for a company. Not only does this eat into profits, but it can hinder cash flow to the point where the business struggles to meet its own liabilities. The important thing to bear in mind is that the risk of bad debt increases over time; the longer an invoice goes unpaid, the greater the chance this has of turning bad. Once an invoice becomes overdue, this should be tenaciously chased up and payment obtained in the swiftest way possible.

Persistence is key

Don’t be shy when it comes to pursuing outstanding payments; you did the work associated with the invoice and it is your right to be financially compensated for this. The way you approach late payers is likely to vary depending on the relationship you have with the debtors, and also how important their custom is to your business.

If they are a key customer, responsible for a significant portion of your turnover, you may want to tread lightly to avoid souring relationships going forwards, although there is an argument that a good customer would not leave you waiting for payment without an explanation or indication of when this could realistically be expected to be made. Regardless of this, chaser emails and letters which progress to phone calls if necessary should be done as a matter of course whenever you are dealing with a non-payer.

Previously good payers suddenly becoming lax in making timely payment can hint that they are experiencing financial distress. Take this as a warning sign and put plans in place to shield yourself and your company from further losses and think carefully before entering into business with them again on the same terms.

Assess your current collection strategies

As with most things in life, in these types of situations, prevention is typically better than the cure. Putting measures in place to mitigate the risk of debt turning bad in the first place is by far the most effective way of dealing with problem payers and the subsequent knock on effects to your company.

Have a look at your current debt collection processes and also consider the circumstances surrounding any bad debt or long-term unpaid invoices you have. Are there any trends you can spot? Perhaps they are all related to new customers or one-off clients, or maybe they are more common following certain kinds of job, or is it the case that larger invoices are particularly affected? Once you know the types of clients or the scope of work which is most likely to cause you problems, you can put steps in place to limit this risk.

Do your due diligence

Doing your due diligence before agreeing to payment terms can save you headaches further down the line. When you allow a customer to pay for their goods after they have been provided, you are extending a line of credit to them akin to a short-term loan. No bank would agree to lend money without first conducting a credit check to ascertain a potential customer’s credit worthiness, and as a business owner, your approach should be no different. There are a variety of software packages on the market which allow you to instantly check the financial health of any limited company in the UK helping you make a sound judgement as to whether you are comfortable offering them credit.

If you have any doubt whatsoever as to a potential client’s ability to pay you on time, don’t be afraid to tailor your payment conditions accordingly. Ask for a larger deposit, reduce your net payment terms, or even insist on payment being made in full before you provide goods or services.

Early action is vital

Take steps before the invoice becomes overdue. Send friendly reminders leading up to the due date to encourage payment to be made. Often invoices fail to be paid due to a genuine oversight on the side of the payer; timely reminders will prevent this happening. This also allows for any concerns regarding the product or service provided to be aired and for these to be dealt with accordingly.

Alternatively if your debtor is deliberately looking to avoid payment, if you make it clear you will not be a soft target and will persistently chase for the money you are owed, they will be more inclined to pay up than if you took a less rigorous approach to your ledger management.

David Tattersall is Head of Client Relations at Handpicked Accountants. David has over 35 years’ experience in professional services working in finance, accountancy and corporate insolvency.

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