What is a Net Charge-Off?
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.
- A net charge-off (NCO) is the amount representing the difference between gross charge-offs and recoveries of delinquent debt.
- Net charge-offs are the debt owed to a company unlikely to be recovered by that company.
- 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.
Understanding Net Charge-Offs (NCO)
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%.
Company Example of a Net Charge-Off
Capital One Financial Corp. reported that total net charge-offs in 2019 as a percent of average loans outstanding was 2.53%, compared to 2.52% in 2018, or an increase of 1 basis point. As per accounting rules, the bank applied the net charge-off amount to the loan loss provision. NCO amounts shed important information to investors about credit standards of lenders and may also provide signals about general economic conditions.