Bad debt
Bad debt is money a customer owes that the business concludes it will never collect, and either writes off or sets aside a reserve for. How consistently a seller has recognized bad debt over time — rather than leaving stale receivables sitting on the books uncollected and unwritten-off — is a direct test of how reliable the rest of the financial statements are.
Every business that sells on credit has some bad debt; the question is whether it gets recognized honestly and on time. A business that writes off uncollectable accounts as it identifies them shows a truer picture of earnings than one that lets old, dead receivables sit on the balance sheet as if they were still worth full value.
Two ways it distorts the numbers
- Overstated assets — receivables on the balance sheet that will never turn into cash
- Overstated earnings — if a bad debt reserve was never built up, or was released to flatter a single year’s results
What a buyer’s diligence checks for
A pattern of bad debt as a stable, small percentage of sales is normal and not a red flag by itself. A sudden jump, a reserve that moves around without explanation, or receivables that are old but were never written off are what draw scrutiny — because each one means the reported earnings may not be as clean as they look.
Sources
This definition is checked against primary sources. Links were last confirmed on the dates shown.
- 01Treadstone LawLegal commentaryHow to Read a Business's Financial Statements Before You Buy in Ontario
- 02Treadstone LawLegal commentaryCleaning Up Financial Statements Before Selling Your Ontario Business
- 03Canada Revenue AgencyGovernmentSelling a business
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