Bad debts and discounts

Once you are comfortable adding receipts to a cash budget, there are few further aspects to consider. How can we persuade our customers to pay early? What happens if our customers can’t pay at all?

Irrecoverable debts

It is possible that some receivables cannot be collected, possibly due to a customer having their own cash flow issues, or going bankrupt, or because of a dispute. Therefore, cash flows will need to be adjusted for the amounts that were due from these receivables. These are known as irrecoverable debts or bad debts.

It may be that a business predicts that a certain percentage of its receivables will not be received and builds this into its cash budget from the start. There might be a specific receivable that they know will not be able to pay. The key rule to remember with irrecoverable debts is that no cash is received at all for these amounts.

Let’s take a look at applying this with an example from Taya’s Bakery.

Irrecoverable debts example

Taya has forecast the total sales for April to be £1,500 but, based on previous experience, she predicts that 10% of receivables will not pay. Remember: this is 10% of receivables – cash receipts are not included in this 10%.

Taya starts by using the same projections to estimate cash and credit sales:

• 20% cash = 20% × £1,500 = £300
• 80% credit = 80% × £1,500 = £1,200

At this stage, Taya then deducts 10% of the receivables as irrecoverable:

• 10% irrecoverable = 10% × £1,200 = £120
• credit = £1,200 − £120 = £1,080

She uses her usual method of predicting when these receivables will be paid, but using the revised receivables figure of £1,080 (rather than £1,200):

• Pay in May = 60% of £1,080 = £648 (was £720)
• Pay in June = 40% of £1,080 = £432 (was £480)

Discounts

A company might offer a discount to their customers to improve their cash flow:

• early settlement discounts can be offered to credit customers to encourage them to settle their debt earlier.
• bulk buy discounts can be offered to encourage customers to place larger orders.

These discounts can prove useful in improving cash flow and liquidity. However, in the long term, less cash will be received from receivables overall. When considering offering a discount, it is worth considering whether the cost of the discount outweighs the benefit.

Taya’s Bakery example

In April, Taya offers one of her customers a 5% discount if they pay in cash rather than on credit. The customer takes her up on the offer. The order was for £200 on credit, but is now £190 in cash:

• 5% of £200 = £10
• Order = £200 − £10 = £190

This affects her cash and credit sales for April as follows:

• cash = £300 + £190 = £490
• credit = £1,200 − £200 = £1,000

Taya then deducts 10% of receivables as irrecoverable:

• 10% irrecoverable = 10% × £1,000 = £100
• credit = £1,000 − £100 = £900

She then uses her usual method of predicting when these receivables will be paid:

• Pay in May = 60% of £900 = £540
• Pay in June = 40% of £900 = £360

The irrecoverable debt and early settlement discount has had an effect on Taya’s cash budget: