The International Monetary Fund issued a warning in 2017 that Canada’s high personal debt levels present a real risk to the Canadian economy, but does that mean you and your clients should be worried? Climbing debt in the consumer market is something small businesses should be aware of, but with a little foresight and planning, you and your clients can mitigate for these risks.
What Is the Effect of This Debt?
The disposable debt ratio has continued to hit record highs in recent years, with another all-time high in 2017 of 167.8%. That means for every dollar spent after taxes and fixed expenses, it collects $1.68 in credit market debt. Having consumers with maxed out credit is a problem for any small business. If your client’s customers have maxed out their credit cards and are using their disposable income to pay off interest rates, that doesn’t leave them with anything to spend on your client’s goods and services.
Bad credit can be a factor here too. Major credit scoring agencies lower the credit scores of consumers who are maxing out their available credit, giving them fewer borrowing options for larger purchases. That’s going to limit the customer base if your clients are in the business of selling expensive goods on credit, such as cars or real estate. If you provide individual accounting services, you might feel the pinch too. Your clients might decide to figure out their taxes themselves rather than pay for professional services when money’s tight.
What Can I Do for My Clients?
To a large extent, your clients need to decide how to adapt their business strategies to account for lower consumer demand on their own. But you can help them make sure they’re properly prepared for the increased credit risk when a large number of their customers have heavy credit debt loads. With a higher debt burden ratio, you can expect more credit risk. Consumers can’t borrow $1.68 for every dollar they spend forever. And rising interest rates can further impact consumers’ ability to pay. For some, that means cutting back on spending and rethinking personal finances, but others may simply default on their loans. If your clients have any direct debt exposure to individual consumers, such as providing services under a payment plan, they should account for this possibility with a bad debt allowance account.
How your clients account for credit defaults depends on whether they use cash or accrual accounting. While small businesses may choose to use the cash accounting method, which records transactions as cash changes hands, your clients may want to consider the accrual method instead. This method requires them to record transactions as they occur, which may be in advance of cash transactions. Under cash accounting, your client writes off bad debts as they occur. They only recognize the bad debt expense when they’re reasonably sure the customer can’t pay. This can make it hard to plan and anticipate future cash flows.
A better approach in a market with high credit risk is to create a bad-debt allowance account under the accrual method. With an allowance account, your clients set aside money in the budget to anticipate for defaults on debt. And as disposable debt ratios rise, you can help them prepare by suggesting they set aside a little more in these accounts. By educating your clients about the potential risks in the credit market and preparing accordingly, you can help them weather uncertainties.