CREDIT WHERE DUE
Bad Debt, Right Decisions
Rolling the dice on risky customers can have larger consequences for company profits than simple logic may suggest. BY JOHN SLOAN
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here’s a conversation that often takes place on a daily basis at radio, television, cable network and newspaper offices that goes something like this: “If we don’t sell it to them, then we won’t be able to sell it to anyone.” “Sure. The inventory is available. It’s better to sell it and take a chance on not being paid than not sell it at all.” It persuasive, because traditional media companies have very perishable advertising opportunities. There is some truth in the assumption that it’s better to sell to a customer who might not pay than not to sell the time or space. However, deciding what’s best for your company is not as simple as it first appears. What is the downside? Before addressing that question, it helps to understand our financial statements. It is only after understanding our finances, specifically the earnings statement, that we can begin to appreciate the advantages and disadvantages of selling to marginal customers. An earnings statement – sometimes known as a profit and loss (P&L) statement – is simply a document that shows the expenses associated with the revenue generated by a company’s sales. Operating expenses listed on the P&L include everything from salaries to supplies to licensing fees. They are sometimes broken out by general and administrative expenses and cost of goods sold. For every dollar of revenue, some expense is necessary to generate that revenue. Here is a simplistic P&L statement for a company we’ll call XYZ Media: Net Sales: Sales and Admin Expense Licensing Fees Net Profit
$1,000,000 -700,000 -150,000 150,000
In this instance, for every $10 in sales that the company makes, it generates $1.50 in profit. Profit does not equal cash. Profit is a mathematical calculation designed to show how well or poorly a company is performing. The cash generated from all sales should end up in the company’s bank account, but there
are no guarantees that that will occur. Part of the operating expense associated with each sale relates to the salaries of the salespeople, assistants, engineers, journalists, managers, accountants and, yes, credit analysts employed by XYZ Media. All of them influence, directly or indirectly, the funds that end up in the company’s bank account. Suppose a salesperson makes a proposal to a customer, and the customer agrees to purchase $100,000 of inventory of XYZ. The schedule is run per the customer’s specifications and an invoice is generated and sent to the customer who pays it within XYZ’s payment terms. Nine other customers do the same thing and XYZ earns $150,000 profit for that period. But what happens if one of those 10 customers has financial difficulty and is forced to file bankruptcy? What if XYZ cannot collect on that sale? The financial statement may look like this: Net Sales: Sales and Admin Expense Licensing Fees Bad Debt Net Profit
$1,000,000 -700,000 -150,000 -100,000 $50,000
XYZ’s profit is substantially reduced because one customer didn’t pay. If it takes $10 in sales to generate $1.50 in profit, then XYZ is going to have to sell another $1 million to make up for the $100,000 loss. If the average sale is $100,000 then it will have to find seven new customers to
8 The Financial Manager • January/February 2020
replace the one customer that didn’t pay. In the real world, companies manage bad debt by establishing reserves so that the effect of bad debt does not have a dramatic impact on earnings. Operating expenses are increased over a period of time to create a reserve. Regardless of how bad debt losses are managed, the impact of a bad debt affects earnings. Obviously, the size of the loss also is important. But bear this in mind: any bad debt loss cannot be made up by selling the same amount to another customer. It involves selling many times the lost amount to other customers. So does it make sense to sell to a marginal credit if there is a reasonable expectation of not receiving payment? The answer must be “no.” Note, however, that not selling the inventory results in zero revenue which also translates into zero profits. Marginal customers can be sold as long as sales and financial management fully recognize the risk of loss. They should be prepared to manage the risk and willing to take decisive action to minimize a loss. John Sloan is a former executive director of credit services for Turner Broadcasting System. He can be reached at john_sloan23@yahoo.com.
