Net Charge-Off (NCO): Definition, Formula & Example
When looking for a loan, a business will tend to turn to a creditor.
But when a borrower defaults and cannot pay back the average loans, the creditor will experience what’s known as bad debt. But every now and then, a small amount may make its way back to the creditor.
That’s where net charge-off comes into play.
Read on as we take you through the definition, the formula, and an example of net charge-offs at work.
Table of Contents
- A net charge-off (NCO) can be defined as the difference between the amount of any recoveries of what’s known as bad debt and the gross charge-offs.
- Bad debt is the debt that is owed to a company that is unlikely to be recovered. This is debt that is saddled on the company that they cannot recover.
- The net charge-off is a useful accounting tool for creditors.
What Is Net Charge-Off?
A net charge-off (NCO) is the difference between the amount of any recoveries of delinquent debt and the gross charge-offs. It refers to the debt that is owed to a company that is unlikely to be recovered.
This is what is known as bad debt. It is debt that is saddled on the company that they cannot recover. This would tend to be if the borrower has gone bankrupt and has insufficient liquid value to cover the size of the debt. This bad debt is often written off and then classified as gross charge-offs. There may be the event that some money is recovered on the debt at a later date. This amount would then be subtracted from the gross charge-offs. This is to compute the value of the net charge-off.
What Is the Formula for Net Charge-Off?
The formula for net charge-off is as follows:
An Example of Net Charge-Off
Let’s say that Company X has gross charge-offs that represent 6% of total loans outstanding. 1% of the total loans outstanding are then claimed as subsequent recoveries. With this information, we can use the NCO formula to calculate the net charge-off:
NCO = 6% – 1%
NCO = 5%
Why Is Net Charge-Off Important?
It is very rare that a lender will always collect the full amount of all of its business loans outstanding. With this in mind, creditors will tend to establish a loan loss provision. This is an estimated amount based on historical data that the lender believes will not be repaid. They would then charge off the amounts that it believes will not be returned.
Most of the time, the loss provision is roughly the actual amount of gross charge-offs. But situations can occur where recoveries happen, which produce a net charge-off figure when netted against the gross charge-offs. The lender can reduce the loan loss provision by the total sum of net charge-offs during an accounting period. They can then refill the provision. The loan loss provision will appear on the income statement of the business. It will go down as an expense, therefore lowering the overall operating profit of the business.
In terms of banking in the U.S., the Federal Reserve Bank tracks the aggregate net charge-off ratios for banks. This ratio is defined as net charge-offs divided by the average total loans during a financial period of time.
Net charge-offs are a useful accounting tool for creditors. It allows them to consolidate and quantify their bad debt amounts and potentially offset these losses in their accounts.
FAQs on Net Charge-Offs
What Is a Good Net Charge-off Ratio?
Realistically you want your charge-off ratio to be as low as possible. This means that a small fraction of your crediting has turned into bad debt.
What Happens if a Loan Is Charged Off?
If a loan is charged off, the creditor will have to write it off as a financial loss.
What Is the Difference Between Charge-off and Write-Off?
There is no difference at all between a charge-off and a write-off. They both mean the same thing.
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