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As a way to minimize the impact of default on a business’s functionality, the default reserve is simply a means of creating a bank of reserve funds to help offset accumulated defaults. Typically, this delinquency occurs when customer bills are not paid and there is little chance of collecting outstanding bills. 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 within the business of factoring accounts receivable for a company. Essentially, a factoring company acquires a bank of invoices from a corporation, with the understanding that the 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 use in the event of default. The percentage withheld is generally calculated based on the average payment patterns shown in previous billing periods involving the same customers. Once all outstanding invoices for the period have been paid and settled, the funds set aside to cover delinquent debt expenses are released and sent to the factoring company’s customer.
Another example of the use of a bad debt reserve concerns the write-off of debt incurred due to a customer’s bankruptcy or exit from the market. Even when a company goes bankrupt and an agreement is reached to allow creditors to collect a small percentage of the outstanding debt, there is often a significant amount of outstanding invoices that the supplier must cancel. A bad debt reserve helps alleviate the trauma of having to write off outstanding bills as uncollected. In addition, the act of using a bad debt reserve to cover these types of losses can also often be used as a deduction on annual tax returns, helping to further alleviate financial loss for the business.
Even a small business may occasionally have a customer who is unable to pay an invoice for one reason or another. Having a bad debt reserve can be particularly important for small businesses, as a large percentage of the revenue generated tends to go to basic operations. When the revenue collected is much less than the amount generated in the bills, a source of funds to make up the difference becomes crucial. Creating a bad debt reserve that is roughly equal to at least thirty days of operating expenses is an excellent way to protect against bad debt and lessen the negative impact on the overall operation of the business.