Definition:
Gross Charge Off can simply be defined as the amount of finance that is not repaid to the bank. In other words, it is categorized as bad-debts for banks, or other financial institutions.
During the operational cycle, banks and other financial institutions are often involved in carrying out transactions with other different organizations who seek financial support from the banks.
However, there are certain times when these organizations are unable to honor their debts. In those cases, the amount that is not recovered from the debtors is written off from the books, and that is referred to as the gross charge off.
Gross Charge Off is an increasingly important metric for the company because it shows how well the credit risk department is functioning within the company.
During the normal course of the business, it is often challenging to guarantee that all the debtors will honor their obligations, and pay back on time.
However, it is then the responsibility of the credit risk department to ensure that companies are able to reduce the amount of irrecoverable debt because that is an expense that has a negative repercussion on the company in terms of profitability.
Formula:
As described earlier, gross charge off is the final amount that the company is unable to collect from its debtors. Therefore, gross charge off can be calculated by adding all the figures of debts that have not been honored by the company.
At the end of the year, organizations mostly do a round-up of collectibles, in order get an idea about the position of the debtors, and if there are any red flags they should look out for.
Depending on those insights, they are able to get an idea about the amount they might not recover. However, they only write the amounts as gross charge offs when they are absolutely certain that the amount can no longer be recovered from the party.
Example:
In order to further explain the concept of Net Charge Off, the following example is provided.
Mia Co. is a bank that that has managed to extend loans worth $2,150,000 over the year end 31st December 2020. However, over the past year, around $ 150,000 were declared as irrecoverable amounts from debtors.
It is anticipated that out of this amount, 10% might be recovered upon liquidation of the company.
In the example above, it can be seen that Mia Co. has irrecoverable amounts of debts amounting to $150,000. Therefore, this is the amount that needs to be written off as a gross charge off.
Regardless of the fact that around 10% of this amount is expected to be recovered, yet it will not be treated as such unless it is actually received by the company.
Importance:
Given the fact that Gross Charge Offs are mostly used by banks, and other financial institutions, it can be seen that it is very important metric for organizations from both, an internal as well as external point of view.
As a matter of fact, gross charge off can be regarded as one of the most important and crucial metrics that hints towards the overall ability of the company to keep their risk profile moderate.
A significant amount of gross charge offs means that the company has a weaker credit control and risk management policy. Therefore, it calls for companies to ensure to implement new standard operational procedures in order to minimize this particular amount of write offs.
In the same manner, it is also considered important for the long-term sustenance and profitability of the company. Otherwise, the bank, or the organization will continue to lose substantial sums of money in the form of bad debts.
In the same manner, even from an investors perspective, a higher gross charge off is considered to be problematic. This is because it shows that the company is not doing that well on grounds of doing a proper background check.
By comparing it with other financial institutions, they can get a relative idea about the industry performance.
Net Charge Off vs Gross Charge Off
Net Charge Off and Gross Charge off is similar, except for the amount that is actually recovered after those bad debts have been written off. In the case no amount is recovered is from the debtors, net charge off is going to be similar to gross charge off.
However, the greater the difference between the net charge off and the gross charge off, the more beneficial it is for the company. This is because it shows that a significant majority of bad debts have finally been recovered.
