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HOW GOOD IS BAD DEBT?


AN ANALYSIS OF FORTUNE 1000 COMPANIES

Patrick Petti

28th July, 2023
No business likes bad debt. But it happens often. We deep dive into revenue loss
incurred by businesses when customers don't pay.


BAD DEBT - A TINY BUT MENACING THREAT

We studied the bad debt to sales ratio of hundred Fortune 1000 companies* in
2022 and 2021. The ratio measures the money a company loses on its overall sales
due to customer(s) not paying their dues.

The average bad debt to sales value in 2022 was 0.16%. The companies with the
best ratio (best performers) reported a value of 0.02% or lower.

On the other hand, the maximum bad debt to sales value (bottom performers)
reported by this group of companies was 1.10%.

A few businesses in the technology, life sciences, and utility industries pushed
the average value higher than the median (0.07%).

While as percentages these figures may look small, in absolute numbers it can
get staggering.

For example, a $1 billion company can lose up to $11 million as bad debt. If it
improves its ratio even by 10%, it can save around $1 million.


WE LOOKED AT THE BEST PRACTICES OF BEST PERFORMERS

Here is what the best performers do continuously to improve their bad debt:



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 * Limit credit risk concentration: Leading companies diversify their credit
   risk and use dashboards to track the concentration of AR with one customer or
   a group of customers. They also mention in their financial filings if any
   customer holds more than 10% of their AR.

 * Periodic credit risk check-ups: Evaluating customers’ financial conditions
   periodically using third-party data and credit risk modelling tools is
   another best practice followed by companies with a low bad debt to sales
   ratio.

 * Strong credit controls: Several companies ask customers to provide letters of
   credit and bank guarantees to prove their creditworthiness. Online credit
   applications have to be correctly submitted before customers can be
   onboarded.

 * Credit risk prediction and management: Real-time credit risk monitoring along
   with robust models to predict customer payments and delinquency helps manage
   bad debt better. The models use a variety of inputs including macroeconomic
   conditions, past payment behavior, credit ratings, etc. It also ensures
   adherence to the credit policy of the company.

 * Electronic workflows: Streamline customer data collection, approvals, and
   onboarding with electronic workflows. It enables accurate data transfer, and
   faster completion of tasks. It helps make better credit decisions faster
   while offering customers a seamless experience.

 * Proactive collections: While strong credit risk management solves collection
   challenges to a large extent, most companies also have dedicated collection
   teams to follow up with customers and manage their grievances. They also
   offer self-service portals to enable customers to make payments, download
   invoices, and track credit limits.


GROW FAST BUT NOT AT THE COST OF BAD DEBT

The average revenue for Fortune 1000 companies grew 20% in 2022 YoY. Despite
this, their bad debt to sales ratio increased marginally, from 0.15% in 2021 to
0.16% in 2022**.

This is an indicator of their robust credit risk management and collections
policies. Their clout as large players may also be enabling them to flex their
'collection muscles'.

Some of the companies also mention using AR factoring to achieve their cash flow
targets and minimize write-offs. AR factoring involves selling past-due invoices
to third-parties at a discount to get immediate cash.


INDUSTRY-WISE ANALYSIS

Here's an industry-wise look at bad debt to sales ratios in 2022 and 2021.

Average bad debt to sales ratio Industry 2021 2022 Trends Technology 0.15% 0.17%
↑ CPG 0.06% 0.05% ↓ Manufacturing 0.05% 0.06% ↑ Life sciences 0.11% 0.13% ↑
Utility 0.34% 0.41% ↑

 * Technology
   
   The technology sector had a boom during the pandemic. But it seems to be
   facing an issue with its receivables as markets take a downward turn. While
   revenues grew 10% in 2022 YoY, the average bad debt to sales ratio also grew
   at a similar pace - 11%.
   
   Also, the range (difference between the max to min value) of the ratio was
   higher compared to other industries. A few players in the industry are having
   more challenges with their receivables than others.

 * CPG
   
   The consumer packaged goods industry recorded sluggish growth in 2022 (4.3%
   YoY). Its bad debt to sales ratio remained steady at around 0.05% - 0.06%
   during both the years. Despite supply chain pressures and inflation, CPG
   businesses have been able to stand their ground on receivables so far.

 * Manufacturing
   
   The manufacturing industry reported steady bad debt to sales ratio in 2022
   and 2021. While their average revenue grew 34%, the bad debt to sales ratio
   increased only marginally (3%).

 * Life sciences
   
   The collection moratoriums issued by regulators had forced healthcare & life
   sciences businesses to temporarily suspend their collections during the
   pandemic years. This impacted their bad debt expenses and write-offs during
   2020-22.
   
   While the revenues grew 10%, the average bad debt to sales ratio grew at
   double the pace (22%). The range of the bad debt to sales ratio for the
   industry was also higher, indicating disparities in healthcare companies’
   ability to collect.

 * Utility
   
   Utility comprises businesses involved in the distribution of power, natural
   gas, and water. Regulatory moratoriums suspending collections affected the
   utility industry receivables in 2020 and 2021. The rising energy prices and
   job losses are reasons for higher delinquency today.

An S&P report mentions that bad debt is a pressing problem for the utility
sector with unpaid bills doubling since pre-COVID times. Revenues climbed 17% in
2022 YoY. The bad debt to sales ratio also grew at a slightly higher pace (18%).


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PREPARING FOR MORE UNCOLLECTIBLES IN 2023 WITH HIGHER ALLOWANCE FOR CREDIT
LOSSES

The allowance for credit loss is an estimate of the accounts receivable value
that the company is unlikely to recover.

From 2023, companies have to adhere to the new accounting standard - current
expected credit loss (CECL) - set by FASB. With the new standard, companies will
have to set the allowances based on expected losses rather than incurred losses.

This allowance is a good indicator of bad debt or uncollectibles for the coming
financial periods.


2022 VS 2021

In 2022, the average allowance for credit loss to AR ratio was 2.3%. In 2021,
the average was slightly lower at 2.2%.

The minimum and maximum allowance ratio values also increased by 20 basis
points. Companies have generally increased or maintained the same credit loss
allowance to AR ratio in 2022.

Allowance for credit loss to AR 2021 2022 Trends Minimum ratio 0.01% 0.03% ↑
Average ratio 2.2% 2.3% ↑ Maximum ratio 7.8% 8% ↑

This suggests that companies are bracing up for higher uncollectibles in 2023
compared to 2022. The threat of recession would likely be the key reason behind
this.


INDUSTRY-WISE OUTLOOK

Here’s a snapshot of how the average allowance for credit loss to AR ratio has
changed for different industries between 2022 and 2021.

Average allowance for credit loss to AR ratio Industry 2022 2021 Trends
Technology 2.3% 2.1% ↑ CPG 2.2% 2.2% ↔ Manufacturing 1.9% 1.9% ↔ Life sciences
3.9% 3.9% ↔ Utility 2.2% 1.5% ↑

 * Technology
   
   The average allowance for credit loss to AR ratio increased for the tech
   industry from 2.1% to 2.3% in 2022. The median value reduced slightly during
   the same period. This indicates that some tech companies are going to have
   more severe bad debt trouble than others.

 * CPG
   
   The CPG industry has maintained the same level of allowance for credit loss
   in 2022 and 2021. Consumer spending in the US hasn’t taken a big hit in 2022
   and H1 2023 despite the rising prices. This is likely keeping CPG companies
   optimistic about their receivables’ health.

 * Manufacturing
   
   The manufacturing industry has maintained a steady credit allowance to AR
   ratio (1.9%) between 2022 and 2021. There does not seem to be much issue with
   receivables in the manufacturing sector.

 * Healthcare
   
   The worst of the uncollectibles seems to be behind for healthcare companies.
   The credit allowance to AR ratio remained constant at 3.9%, while the median
   declined slightly.

 * Utility
   
   Bad debt across utility companies is expected to remain higher in 2023 vs
   2022. The allowance for credit loss to AR ratio increased to 2.2% in 2022
   from 1.5% in 2021. The median value also increased to 0.87% from 0.84%,
   indicating that most utility businesses will face pressure on their
   receivables.


TACKLING THE RISING BAD DEBT CHALLENGE

Along with higher interest rates, rising bad debt will pose a challenge for
businesses globally in managing their cash flow in 2023.

Benchmark yourself against the ratios we discussed in this report and follow
credit risk management and collection best practices to minimize write-offs.


*METHODOLOGY

We analyzed the SEC filings of 100 companies from the Fortune 1000 list to
identify bad debt values, bad debt to sales ratios, and allowances for credit
losses. The 100 companies were randomly chosen from clusters of 100 each
according to ranking.

** With some outliers, the bad debt to sales ratio increased by 39% to 0.25% in
2022.

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