Credit losses can have a significant impact on a company’s financial health. When a client fails to pay, the effect can be seen on both the income statement and balance sheet. Understanding how these losses affect your financials is crucial for maintaining stability and planning for the future.
Why It Matters
A credit loss occurs when a customer is unable to fulfill their payment obligations, whether due to insolvency, financial hardship, or other factors. The bottom line: When this happens, your company absorbs the loss, which can reduce profitability, strain cash flow, and weaken your financial position.
The Income Statement Impact
The income statement shows your company’s financial performance over a specific period. A credit loss directly impacts your profitability.
- Revenue reduction: When an invoice goes unpaid, you don’t receive the expected revenue. This results in a direct hit to your top-line earnings, reducing the total revenue reported.
- Increase in expenses: Credit losses often require setting aside funds as “bad debt expense” to cover anticipated non-payments. This increase in expenses lowers your net income, affecting your overall profitability.
- Net income drop: The combination of reduced revenue and increased bad debt expenses causes your net income to drop. What you need to know: Credit losses can significantly reduce profitability, even if your sales figures remain strong.
The Balance Sheet Impact
The balance sheet provides a snapshot of your company’s financial position at a specific point in time. Here’s how a credit loss impacts it:
- Accounts Receivable (A/R): Accounts receivable is the money owed to your company by customers. A credit loss means that certain accounts may need to be written off, reducing the total A/R value on your balance sheet.
- Allowance for doubtful accounts: Companies typically set up an allowance for doubtful accounts, which is a contra-asset account that reduces the total value of A/R. Credit losses increase this allowance, reflecting the risk of future uncollected payments.
- Shareholders’ equity: As credit losses reduce net income, retained earnings also decline. This weakens the company’s equity position, making it less attractive to investors.
Be smart: Protecting your company from credit losses with credit insurance can prevent these negative impacts.
Sample Case Study: ABC Manufacturing
Let’s explore the impact of a credit loss through the lens of a hypothetical company, ABC Manufacturing.
Background: ABC Manufacturing supplies industrial equipment to businesses around the world. One of their major clients, XYZ Corp, files for bankruptcy and fails to pay a $100,000 invoice.
Income Statement Impact:
- Revenue loss: ABC Manufacturing must write off the $100,000 as a loss. This means that despite the sale, the revenue won’t be realized, reducing their top-line revenue by $100,000.
- Bad debt expense: To account for the loss, ABC also records a bad debt expense of $100,000. This increases their operating expenses, further reducing net income.
Before the credit loss:
Revenue: $5,000,000
Expenses: $3,500,000
Net Income: $1,500,000
After the credit loss:
Revenue: $4,900,000 ($100,000 less)
Expenses: $3,600,000 ($100,000 added)
Net Income: $1,300,000
Balance Sheet Impact:
- Accounts receivable: Before the credit loss, ABC Manufacturing’s accounts receivable stood at $500,000. After writing off the XYZ Corp invoice, A/R is reduced to $400,000.
- Allowance for doubtful accounts: ABC now has a higher allowance for doubtful accounts, reflecting the increased risk of future non-payments.
- Shareholders’ equity: With net income reduced by $200,000, retained earnings drop, and shareholders’ equity declines, weakening ABC’s financial position.
Before the credit loss:
Accounts Receivable: $500,000
Shareholders’ Equity: $2,000,000
After the credit loss:
Accounts Receivable: $400,000
Shareholders’ Equity: $1,800,000
What’s Next
To mitigate the impact of credit losses, companies should implement proactive measures like credit risk management, trade credit insurance, and regular reviews of clients’ financial health. Go deeper: Consider working with a broker to tailor a credit insurance policy that fits your business needs.
Conclusion
Credit losses can quickly undermine a company’s financial health, affecting both the income statement and balance sheet. The bottom line: By understanding the financial impact and taking preventive measures, businesses can safeguard their profitability and maintain strong financial stability.
Since 2004, Securitas Global Risk Solutions, LLC (“Securitas”) has helped clients develop credit and political risk transfer solutions that provide value on numerous levels. As an independent trade credit and political risk insurance brokerage, Securitas is focused on developing comprehensive solutions that meet the needs of clients, ensuring a complete understanding of policy wording and delivering excellent responsive service.
