A net charge-off (NCO) is the dollar amount representing the difference between gross charge-offs and any subsequent recoveries of delinquent debt. It reflects the debt a company is unlikely to recover. As this ‘bad debt’ is often written off and categorized as gross charge-offs, any future recoveries are subtracted from the gross amount to determine the net charge-off value.
Key Takeaways
- A net charge-off (NCO) represents the difference between gross charge-offs and recoveries of delinquent debt.
- Net charge-offs indicate the debt a company is unlikely to recover.
- The Federal Reserve Bank tracks aggregate net charge-off ratios for banks in the U.S.
Dive Deep into Net Charge-Offs (NCOs)
It’s uncommon for a lender to achieve 100% collection on all outstanding loans. Lenders typically establish a loan loss provision, estimating the amount expected to be uncollectable. This provision relies on historical data and trends. The amounts determined uncollectable are then charged off against this provision.
Though loan loss provisions often align closely with gross charge-offs, delays in recovery can occur, leading to net charge-off calculations. A lender reduces the loan loss provision by the net charge-off amount within an accounting period and subsequently replenishes the provision. This provision appears on the income statement as an expense, hence lowering operating profits.
The Federal Reserve Bank monitors aggregate net charge-off ratios for U.S. banks, defined as net charge-offs divided by average total loans for a given period. Breakdowns include categories such as real estate (residential, commercial, farmland), consumer, leases, commercial and industrial (C&I), and agricultural loans. As an example, the seasonally adjusted net charge-offs to total loans for banks ratio in the first quarter of 2022 stood at 0.21%.
Real-World Example of a Net Charge-Off
For instance, in 2019, Capital One Financial Corp. reported total net charge-offs as 2.53% of average loans outstanding, a slight increase from 2.52% in 2018. According to accounting standards, the bank adjusted the net charge-off amount to the loan loss provision. NCO data provides valuable insights to investors regarding lenders’ credit standards and might also indicate general economic conditions.
Related Terms: gross charge-offs, bad debt recovery, loan loss provision, operating profits, Federal Reserve Bank.
References
- Board of Governors of the Federal Reserve System. “Charge-Off and Delinquency Rates on Loans and Leases at Commercial Banks”.
- Capital One. “2019 Annual Report”, Page 15.
