Bad Debt Reserve: Explanation, Use as Financial Health Indicator

What Is a Bad Debt Reserve?

A bad debt reserve is the dollar amount of receivables that a company or financial institution does not expect to actually collect. This includes business payments due and loan repayments. A bad reserve is also known as an allowance for doubtful accounts (ADA).

How Bad Debt Reserves Work

A bad debt reserve is a valuation account used to estimate the portion of a company's accounts receivables or a bank's loan portfolio that may ultimately default or become uncollectible. There are two benefits from this reserve.

For accounting purposes, the bad debt reserve allows the company or bank to state the face value of its receivables or loans. The reserve resides in a different area of the balance sheet, so the net result is that the value of receivables/loans reflects their expected value. Of course, if some of the bad debts pay, the result would be a bump to the bottom line.

The second benefit is a margin for error with regard to planning cash flows. If the company is prepared for default, then it will not be as affected by it.

When a specific receivable or loan balance is actually in default, the company reduces the bad debt reserve balance and reduces the receivable balance because the default is no longer simply part of a bad debt estimate. After this entry, the accounting records have a balance in bad debt expense and a reduction in the loan receivable balance for the loan that actually defaulted.

If a company has $1 million in receivables but one of its customers, which owes $50,000, is undergoing problems in its own business, the company might push the entire $50,000 to bad debt reserve. It still has $1 million in receivables but expects that in the end, it will only be worth $950,000.

How much a company keeps in reserve depends on the company, management, and the industry it is in. Some use a simple percentage of sales or a historical average. An alternative could be based on the debt's age, with the older debts less likely to pay. In some cases, a company might rate each customer individually. Still, others might use a combination of a percentage plus scrutiny of its riskiest accounts.

Bad Debt Reserves As a Health Measure

Most companies and banks keep a bad debt reserve because some percentage of customers will fail to pay. Analysts keep track of changes in bad debt reserves, which can uncover other financial health problems in a company. This includes how effectively a company manages the credit it extends to customers.

For a company, the most glaring problem might be a sharp increase in the reserve as it does business with riskier customers. This could jeopardize the company's cash flow.

On the other end of the spectrum, the company may pay out its reserves now to give off a weaker current condition. Future performance would look better, in contrast, because the estimate for doubtful accounts would appear lower.