Tax & admin · 12 June 2017

What is bad debt and how can I avoid it?

What is bad debt?
What is bad debt?

Here, Emily Coltman, chief accountant to FreeAgent, draws on her expertise for Business Advice readers to answer one of the most important questions for new founders – what is bad debt?

If you’re new to business – or are thinking about starting up on your own – one hazard you may have heard of is exposure to “bad debts”.

But what exactly are these, and how can you protect your business from them? Use the below tips to minimise your business’s bad debt risk.

What is bad debt?

Simply, a bad debt is when one of your customers doesn’t pay your bill. A doubtful debt is when you think a customer might not pay – a bad debt is when they definitely won’t pay, for example they dispute the bill or they’ve gone out of business.

Bad debts are bad news, because they mean your business has less cash than you planned for, and may not be able to afford to pay its own bills. In the worst case scenario, bad debts can make you go out of business, too.

How can I reduce the risk of bad debts?

Here are some tips for avoiding, as far as possible, bad debts in your business.

  1. Do not have just one large customer

I have seen businesses which have only one customer, and that customer is a very large business – and unfortunately large businesses are notorious for paying their smaller suppliers late.

If you only have one large customer, what happens if that business switches suppliers, or goes out of business? Your business will have no further supplies of cash and is at very real risk of having to stop trading.

Don’t risk it – spread your services!

  1. Do your due diligence

Before you take on a big piece of work for the customer, check them out. Look at their accounts on Companies House or DueDil if their business is a limited company, and see if their business is solvent – in other words, if the total sum at the bottom of their balance sheet is positive. If this figure has a minus in front of it, that is not good news!

Look on social media, especially Twitter, to see if there are any queries to them from suppliers who haven’t been paid.

  1. Ask your customers to sign payment terms

Before you do any work for your customers, present them with a one-page summary of your payment terms, including how much you expect to be paid as the project progresses, and when payment is due.

Make sure this includes a clause that says that if payment is late, you will stop any further work until payment arrives. Do not start any work on your customer’s project, or deliver them any goods, until the customer has signed this page to say they agree it.

  1. Take payment up front

As part of your payment terms, ask for part or full payment up front – and make sure the money has cleared into your bank account before you start work.

Taking payment up front helps ensure your customer is committed to having the work done and spreads the risk. If you wait until after you have done the work to ask for payment, then you risk having lost both time and cash.

  1. Make it easy for customers to pay you

The easier it is for customers to pay, the more readily they will do so. Put your bank details on all of your invoices – don’t assume that a returning customer has a copy of their previous invoice to hand.

Collect payment by Direct Debit using a service such as GoCardless, or online using a system like PayPal or Stripe. Don’t ask customers to send cheques, because that is time-consuming and labour-intensive both for you and for them.

Bad debt risk isn’t one that can be completely eliminated from your business, but by following the above steps, you should at least be at less risk of losing money when customers don’t pay you.

Emily Coltman FCA is chief accountant to FreeAgent, award-winning cloud accounting software provider for freelancers and micro business owners

Catch up on some of Emily’s previous Business Advice articles:

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ABOUT THE EXPERT

Emily Coltman is chief accountant to FreeAgent, provider of cloud accounting software for freelancers, micro businesses and accountants. She is passionate about helping the owners of small and growing businesses to escape their “fear of the numbers” and she translates small business finance and tax into practical common sense speak.

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