bad_debt

Bad Debt (also known as a 'non-performing loan' or NPL) is a loan that is in or close to default because the borrower has failed to make scheduled payments of principal or interest for a specified period, typically 90 days or more. For a lender, such as a bank or a company that sells on credit, a bad debt is a serious problem. It transforms an expected source of income into a loss. The money is no longer a productive asset on the company's balance sheet; instead, it becomes a financial black hole. The level of bad debt is a crucial health indicator for any lending institution and, on a larger scale, for the economy itself. A sudden spike in bad debts can signal sloppy lending practices or the beginning of an economic downturn, making it a critical metric for any prudent investor to watch.

Understanding how a company accounts for bad debt is like peeking behind the curtain of its financial health. It’s a two-act play of anticipation and resolution.

Initially, a loan is recorded as a healthy asset, often under 'accounts receivable' or 'loans receivable'. It represents a future cash inflow for the company. Everyone is happy. However, if the borrower starts missing payments, the clock starts ticking. After the grace period expires (e.g., 90 days of non-payment), the loan is reclassified from a performing asset to a non-performing one. It's now officially a bad debt—a regrettable situation that must be dealt with on the books.

Prudent companies don’t wait for disaster to strike. They anticipate that a small fraction of their loans will inevitably go sour.

• The Provision: Companies regularly set aside an amount of money to cover these expected losses. This is called the allowance for doubtful accounts or, in a bank's case, the provision for loan losses. This provision is treated as an expense on the income statement, which reduces the company's reported earnings in the current period. Think of it as a squirrel stocking up nuts for the winter; it's a preemptive measure that ensures the company is prepared for future troubles.
• The Write-Off: When a specific loan is deemed truly unrecoverable (perhaps after failed collection attempts or bankruptcy), the company performs a write-off. The bad loan is removed from the asset side of the balance sheet, and the loss is deducted from the 'allowance for doubtful accounts' that was previously set up. If the write-off is larger than the allowance, the excess loss directly hits the company's earnings, which can be very painful. If the company later manages to recover some of the money, it's recorded as a 'bad debt recovery'.

For a value investing practitioner, analyzing bad debt is not just about crunching numbers; it's about judging the character and competence of a company's management.

A consistently high or rapidly rising level of bad debt is a giant red flag. It often points to a breakdown in a company's risk management.

• Lax Lending Standards: Did the bank get carried away during an economic boom and start lending to anyone who could fog a mirror? A surge in bad debts later on reveals poor credit risk assessment.
• Economic Foresight: Bad debt levels are closely tied to the economic cycle. They tend to rise as an economy weakens and fall during expansions. A sharp increase across the banking sector can be an early warning sign of a coming recession. As Warren Buffett famously says, “It's only when the tide goes out that you discover who's been swimming naked.” A recession is the tide going out, and companies with poor lending standards are the ones left exposed.

To assess a company's handling of bad debt, you need to roll up your sleeves and dive into its financial statements, particularly the annual and quarterly reports.

• Where to Look: The 'provision for loan losses' will be on the income statement. The 'allowance for doubtful accounts' and the total 'non-performing loans' will be on the balance sheet or, more likely, detailed in the notes to the financial statements.
• What to Analyze:
  1. Trend Over Time: Is the NPL Ratio (Non-Performing Loans / Total Loans) increasing? A steady rise is a worrying trend.
  2. Peer Comparison: How does the company's NPL ratio compare to its direct competitors? A bank with a 3% NPL ratio is in much worse shape if its peers are all at 1%.
  3. Coverage Ratio: This is a crucial measure of prudence. Calculated as Allowance for Loan Losses / Non-Performing Loans, it tells you how well the bank's 'rainy day fund' covers its current bad loans. A ratio above 100% is a sign of conservative management, suggesting the bank has more than enough set aside to absorb expected losses. A ratio below 100% means any unexpected trouble could directly hammer its profits.

The 2008 Financial Crisis is the ultimate cautionary tale about the destructive power of bad debt. In the years leading up to it, many banks aggressively marketed subprime mortgages—loans to borrowers with weak credit histories. When the U.S. housing bubble burst, property values plummeted, and millions of these borrowers defaulted. These mortgages turned into a tsunami of bad debt that overwhelmed the banks. Their provisions were woefully inadequate for a crisis of this scale. Massive write-offs vaporized their earnings and destroyed their regulatory capital, leading to the collapse of institutions like Lehman Brothers and requiring massive government bailouts for others. This historical event starkly illustrates how misjudging and under-provisioning for bad debt can threaten not just a single company, but the stability of the entire global financial system.