Monday, April 26, 2010

Allowance for Doubtful Collection

In continuing with the thoughts on revenue from last week, I thought it might be worthwhile to look to look at allowance for doubtful collection of funds. Generally, there are two methods which are used: % of receivables and the aging method.

The first method, % of receivables is quite simple and self explanatory. There is a predetermined percentage of receivables (calculated based on historic numbers) which is expected to default.

So assume that this is 1.85%. If the firm's gross revenue is $1M (and all credit sales), then the expected bad debt associated with those revenues is $18.5k. The net value of receivables is $1M - $18.5k or $981.5k.

The aging method is more sophisticated and provides a better picture, however, it requires a great deal more work.

For example: Assume the following definitions:
Normal - Receivables is between 0 and 60 days old (99% chance of collection)
Distressed – Receivables is between 60 to 90 days old (95% chance of collection)
In Default – Receivables over 90 days old (50% chance of collection)

Now assume that of that $1M, there is:
$900k of Normal AR
$90k of Distressed AR
$10k of In Default AR

The expected value of those receivables would be:
Normal – $900k x 99% = $891k
Distressed – $90k x 95% = $85.5k
In Default – $10k x 50% = $5k
Total value = $981.5k

I’ve chosen very particular numbers to get the same result as above, but this also proves a point. If the structure of your debts is predictable enough (or with little variation), a percentage of receivables method is essentially a sort of weighted average of probable defaults.

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