Definition:
During the normal course of the business, there are numerous different transactions that take place on credit. In this regard, it can be seen that not all credit transactions have a complete recovery rate.
In the case where the organization has bad debts, the amount is supposed to be written off from the records of the company. In that particular case, the write-off is referred to as Gross Charge Off.
It must be noted that gross charge off is normally the term that is used for banks, and other financial institutions. Gross charge-off can therefore be described as the amount that is declared as irrecoverable by the organization.
However, there are certain cases when the company is able to retrieve some of the finances from the general public. In that particular case, it can be seen that the amount is then declared as a net charge-off.
Therefore, net charge off is the final amount that needs to be written off the financial statements, because this is the amount that is declared as bad debt for the organization.
Formula:
As described earlier, Net charge-off is the final amount that the company is unable to collect from its debtors. Therefore, net charge off can be calculated using the following formula:
Net Charge Off = Gross Charge Off – Amount of Bad Debt recovered
Where Gross Charge off is described as the amount that was previously written off as bad debts.
Example:
In order to further explain the concept of Net Charge Off, the following example is provided.
Care Co. is a company dealing in automobile manufacturing. Over the past year, they extended loans amounting to $100,000 to various different parties. However, two of those parties defaulted during the year-end, and therefore, the amount needs to be written off.
The amounts that both these companies owed were $15000 and $5000 respectively. Additionally, it is to be noted that upon the liquidation of both the companies, the amounts that were received by Care Inc. against the amount owed were $4000 and $1000.
In the example above, it can be seen that Care Inc. suffered a financial loss in the form of bad debt amounting to $15000 and $5000 respectively. The amount was declared as bad debt for the company. Therefore, Gross Charge Off amounted to $20,000.
However, the amount that was recovered from both the parties was calculated as $4000, and $1000 respectively. Hence, in this case, the net charge off that is going to be represented in the financial statements is going to be as follows:
Net Charge Off = Gross Charge Off – Amount Recovered = 20000 – 5000 = $15000.
This is the net amount that is declared as irrecoverable bad debt, and therefore, this should be the amount expensed in the Income Statement prepared at the year-end.
Importance:
Net Charge Offs are mostly used by banks and other institutions that extend loans to other companies. In this regard, it is important to ensure that this is a very important concept, which is used as a metric to evaluate the credit risk policy of the company.
A higher amount of net charge offs is an indication that the company has a significant amount of bad debts, and this particular amount needs to be reduced in order to ensure that the company sustains itself in the coming years.
Since this loss is directly subtracted from the operating profit of the company, it can be seen that it is important for companies to realize the fact that they need to rethink and revamp their credit risk policy, so that there are no bad debts in the forthcoming years.
From an investor’s perspective too, a higher net charge off is not favorable, 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’s performance.
Net Charge Off vs Gross Charge Off
Net Charge Off and Gross Charge off are 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.
