What is a Net Charge-Off (NCO)?
A net charge-off (NCO) is the dollar amount representing the difference between gross charge-offs and any subsequent recoveries of delinquent debt. Net charge-offs refer to the debt owed to a company that is unlikely to be recovered by that company. This “bad debt” often written off and classified as gross charge-offs.
A net charge-off (NCO) is the dollar amount representing the difference between gross charge-offs and any subsequent recoveries of delinquent debt. Net charge-offs refer to the debt owed to a company that is unlikely to be recovered by that company.
This “bad debt” often written off and classified as gross charge-offs. If, at a later date, some money is recovered on the debt, the amount is subtracted from the gross charge-offs to compute the net charge-off value.
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.
Understanding Net Charge-Offs (NCOs)
It is highly unlikely that a lender will experience 100% collection on all of its loans outstanding. As a routine matter, a creditor will establish a loan loss provision, an estimate of the amount that it thinks (based on historical data) will not be repaid, and then charge off the amounts that it determines will not come back.
Most often it is the case that loss provisions are in the ballpark of actual gross charge-offs, but eventual recoveries can occur, which when netted against gross charge-offs produce a net charge-off figure. A lender will reduce the loan loss provision by the amount of net charge-off during an accounting period and then refill the provision. The loan loss provision appears on the income statement as an expense and therefore will lower operating profits.
The Federal Reserve Bank tracks aggregate net charge-off ratios for banks in the U.S. The ratio is defined as net charge-offs divided by average total loans during a period. There is also a breakdown among the categories of real estate (residential, commercial, farmland), consumer, leases, commercial and industrial (C&I), and agricultural loans. The net charge-offs to Total Loans for Banks ratio during the third quarter of 2020 was 0.51%.
How Net Charge-offs Work
Most debtors lend out money with the expectation that they will not be able to recover 100% of the loans they’ve issued. Therefore, it is common practice to establish a loan loss provision commonly in the form of “provision for credit losses (PCL).”
The provision is estimated based on historical data from creditors, the economy, and forecasted expectations for collections. The estimation for uncollectable amounts is written off as a gross charge-off.
However, if debtors are able to recover some of the amount that’s been charged-off, then it can net the recoveries against the gross charge-offs to arrive at net charge-offs. The loan loss provision is reduced by the amount of the net charge-off at the end of the accounting period and is subsequently refilled for the next accounting period based on new estimates for loan losses.
Formula Net Charge-offs
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.
Importance of Net Charge-offs
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.
Example of Net Charge-offs
Company A books gross charge-offs that represent 3% of total loans outstanding. Some 0.5% of the total loans outstanding end up being repaid. What is the net charge-off?
The net charge-offs are the difference between gross charge-offs and the amount of loans paid back.
Therefore, the net charge-offs are 2.5% (3.0% – 0.5%) of total loans outstanding.
The amount is applied to the loan loss provision in the accounting statements.