Definition:

Bad Debt, also known as Doubtful Accounts, refers to the portion of accounts receivable that a company does not expect to collect due to customers' inability or unwillingness to pay.

Examples

1. A retail store that sells on credit may have customers who default on their payments.
2. A construction company may have clients who declare bankruptcy, leaving outstanding invoices unpaid.

Formula:

Bad Debt Expense = (Beginning Accounts Receivable + Credit Sales - Ending Accounts Receivable) - Cash Collections

How to use the metric:

Businesses use the Bad Debt metric to estimate the amount of receivables that will not be collected, allowing them to adjust their financial statements accordingly. It helps in assessing the credit risk and effectiveness of the company's credit policies.

Limitations:

1. Estimation: The calculation involves estimates, which may not always be accurate.
2. Variability: Economic conditions can cause fluctuations in bad debt levels, making it difficult to predict consistently.
3. Subjectivity: Different companies may have varying criteria for what constitutes a bad debt.

Applies to:

Industries with significant credit sales, such as retail, manufacturing, and telecommunications, where businesses often extend credit to customers.

Doesn't apply to:

Industries that primarily operate on a cash basis, such as some service-based businesses, may not find this metric as relevant because they do not extend credit to customers.

Summary:

Bad Debt or Doubtful Accounts is a financial metric used to estimate the portion of accounts receivable that a company does not expect to collect. It is crucial for businesses that extend credit to customers, helping them manage credit risk and adjust financial statements. However, it involves estimation and can be subjective, with varying applicability across different industries.