I wanted to explain about “Bad Debt” for quite a while but I was not quite sure how to go about it. I am sure most of you will know about the financial turmoil that the world is facing and that is mostly attributed to the US and the bad debt of US. I had read about the same lots of time but it was way too complicated and it had all the financial terms that I could not clearly put across. Recently I had a talk with one of the acquaintance and that led me to write this article.
In simple words bad debt is a debt in which the person can’t pay back the money and he does not even have assets so that the debt can be recovered from him. Imagine that Mr. Ram owns the fitness club and he has around 100 customers. He makes per month Rs. 1 Lakh as he charges Rs. 1000 from each of his customers. The cost to run the fitness club is as follows: Rs. 60,000 for rent, Rs.10,000 for trainers and Rs.20,000 as EMI for bank which he had taken for the initial investment for the equipments. He has to pay for the next 5 years to complete his loan. The loan was given to him as he has a sound financial business plan and he was making a handsome ROI. The loan was not given to him depending on his financial status or assets as he had nothing.
Imagine a situation where in some 50 customers start defaulting i.e. they use the services provided in the fitness club and don’t turn up to pay the monthly fee as they are laid off in the respective companies. This is a sad state for Mr. Ram as the number of customers has decreased and the income has decreased to half i.e. Rs. 50,000. He does not know what to do as this is going to throw up many issues to him.
Mr. Ram ensures that he gets the fee in the beginning of the month itself and then the patrons can use the service, in this way he can be sure that whoever uses the service have actually paid for it. The patrons who had used the services and did not pay becomes a hard thing to recover since when a person joins in these clubs it is mostly in the good will they are given membership and their personal details are not verified.
It becomes even more difficult for Mr. Ram to run the fitness club as he starts to default the bank and land lord and he is not even able to pay the trainers. He decides to close down the gym and pay up the land lord and bank and start afresh. When he tries to sell the gym equipment, there are not many buyers who genuinely want to buy it. Even if there are genuine buyers, the rate at which they are asking is not a good one for Mr. Ram. Hence Mr. Ram just decides to quit the fitness club business. Closes down it and asks the bank to take over as he is not able to pay the EMI.
Bank takes over the gym and starts selling the equipments and tries to recover the investment that it had made. However after all the assets have been liquefied it is just able to get only 60% of the loan amount that it had given. The rest 40% is nothing but “Bad Debt”. The bank is at loss in the whole cycle.
The US bank officials gave loan to people who just had a job and did not have any assets. When these people lost their jobs they started to default the bank and this led to the financial crisis that we are facing. Hope you have understood what “Bad Debt” means. 🙂
Engineer's Finance 