15 Jan
Creditors and Debtors Explained
Creditors and Debtors explained with definitions and descriptions
Creditors and Debtors might seem like simple terms, and on the face of it they are, but the practicalities of how the two terms can be applied can quickly become confusing, this is mostly the case if you are a small business. As with many financial terms, it’s easy to get them confused, so it’s important to clearly understand the difference.
We have explained debtors and creditors in simple terms initially, we have also explained them in more detail and in the context of businesses and companies as well further down in the article.
What is a debtor?
At it’s most basic, a debtor is a party that owes money to another party. Who that party is can vary dramatically? It can be a single person, it can be a small business, it can be a big business, it can even be a government. If money is owed, the party owing that money is known as the debtor – they have the debt. Money is loaned, usually in a lump sum. Repayments are then made over a pre-determined period of time until the loan is paid off. Usually, in addition to the value of the loan, there will be interest in addition. This is where the incentive comes to loan money: the interest can be considered profit on the transaction. It’s quite possible to be a debtor and to have debtors at the same time, particularly as a small business.
What is a creditor?
A creditor is a party who has loaned the money to the debtor. It doesn’t have to be cash: a loan can comprise anything that has perceived or practical value, for example, stocks, or equipment. Creditors are generally comprised of banks, building societies, and other financial institutions. However, there is a rising trend for alternatives, such as peer-to-peer lending. There may be other businesses or even government institutions that might lend to businesses. The term “creditor” is not exclusive to any one particular field or institution. It’s very possible that you, as a small business, might find yourself being the creditor to a debtor.
Pro and cons of Debtors & Creditors
Products and services may often be prohibitively expensive to pay for up front, or in one lump sum. Financing allows an individual or business to have use of the asset while paying for it in more manageable instalments – often weekly, monthly, or sometimes quarterly. The benefit for the debtor is that they get access to funds or equipment that would otherwise be beyond them. This allows them to continue to build their business, so in some sense, the loan could be considered an investment in a business’ own ability to grow. The drawback is that a debt is considered a business liability, and non-payment may result in further penalties and potentially even legal action. The benefit for the creditor is that to be able to make a loan is the sign of a healthy and thriving business. There is also profit to be made in the form of interest paid on every loan repayment – so the ultimate amount paid back will be more than what was borrowed. The drawback is there is potential for non-payment, forcing the creditor to pursue potentially expensive legal proceedings to get what they’re owed.
Debtors & Creditors explained in more detail from a Business or Company Perspective
The nature of business is such that it allows them to buy or sell to each other on agreed terms with cash exchanging hand at later dates, this is called credit. This isn’t a new concept and has existed for a long time. When a buyer and seller begin selling and purchasing products on credit, their relationship changes into a relationship of a debtor and a creditor.
What is a debtor?
A debtor can be an entity, a company or a person of a legal nature who owes money to someone else. A business or a person who has one or more debtors is called a creditor. In other words, the relationship that a debtor and a creditor share is complementary to the relationship that a customer and supplier share.
Why do businesses need to keep an eye on their debtors?
Businesses make sure that they keep an eye on their debtors because managing their debtors in the right way ensures that they get paid faster resulting in far less bad debts. In addition to this, collecting debtors accounts promptly makes sure that there is a healthy flow of cash. Managing debtors are usually referred to as credit management and includes the following –
- Timely debt collection
- Setting up credit limits as well as payment terms
- Making credit checks as well as credit applications
- Enforcing a clear credit policy
- Considering debtor finance.
What is a creditor?
A creditor can be anyone from a bank, supplier or a person who has provided goods, money or services to a business or person with the expectation of being paid back at a future date. A creditor is someone who is owed money by a company.
A secured creditor is a creditor who has a registered lien on some of the businesses or person’s assets while an unsecured creditor is a creditor without a lien on their assets.
Why do businesses keep an eye on their creditors?
Businesses keep an eye on their creditors for a variety of reasons. Knowing how much a business owes as well as how much they are owed and when payments must be made or received lets businesses have an idea of their cash flow over the next several months. It also makes sure that businesses have enough money in the bank for business payments which could be anything from salaries, to rent as well as other overhead payments.
As you can see, it’s very important for businesses to keep an eye on their creditors particularly if their businesses are seasonal which means that they might need to pay suppliers several months before their customers pay them.
What are debtor days and what are creditor days, and why do these terms matter to a business?
The terms debtor days and creditor days are used to referring to the average number of days that a company lets pass before its debtors pay as well as the average number of days a company lets pass before its creditors are paid respectively.
Creditor days are used to measure a company’s creditworthiness as well as reputation and to a certain degree, creditor days determines the latitude allowed by its suppliers as well as creditors. Creditor days can also reflect the value that both parties put on the business conducted as well as act as a reflection of the company’s cash flow and the extent that it’ll go to finance its business with its debt. Companies which have a habit of delaying payments excessively will eventually face penalization which creates issues in getting supplies.
Debtor days are used as an indication of how efficiently a company invoices for goods as well as services and collects from its customers. Fewer debtor days are better for a company. Delays in payment tells a company that their customers are facing cash-flow problems, that they might be overstocked, or are being held to ransom by some of its own customers due to their size and power, such as big supermarket chains. These types of customers usually fall victim to harsh credit terms as well as lower service levels.
How are creditor days calculated?
Dividing total debt by sales revenue and multiplying the answer by 365 will calculate creditor days. A debt of £ 800,000 with sales revenue of £ 9 million will be calculated like this –
(800,000/9,000,000) x 365 = 32.44 creditor days
How are debtor days calculated?
Dividing the total outstanding debt by sales revenue and multiplying the answer by 365 will calculate debtor days. Outstanding debt of £ 600,000 with a sales revenue of £ 9 million will be calculated like this –
(600,000/9,000,000) x 365 = 24.33 debtor days
What is the Difference between debtors and creditors?
If you’d like to know a couple of differences between debtors and creditors, have a look at the following points.
- Debtors have a debit balance to the firm while creditors have a credit balance to the firm.
- Payments or the amount owed is received from debtors while payments for a loan are made to creditors.
- Debtors are shown as assets in the balance sheet under the current assets section while creditors are shown as liabilities in the balance sheet under the current liabilities section.
- Debtors are an account receivable while creditors are an account payable.
- The term debtor comes from the word ‘debere’ of Latin which means no owe while the term creditor comes from the word ‘creditum’ of Latin which means to loan.
- Discount is offered to debtors by the person who extends credit while creditors offer discounts to the debtors to whom they extend credit to.
The main differences between debtors and creditors are as follows –
- Creditors extend the loan or credit to a person, organization or firm while debtors take the loan and in return have to pay back the money within a stipulated time period with or without interest.
- Creditors can offer discounts to debtors while debtors are the ones who receive discounts.
- Creditors are the parties who debtors should pay back.
- Debtors are mentioned under the category known as accounts receivable while creditors come under accounts payable.
- No provision of doubtful debt is created for creditors whereas a provision of doubtful debt is created for debtors.
Conclusion
Business transactions, at their simplest, have two parties involved which are the creditor and debtor. In short, a creditor is someone who lends money while a debtor is someone who owes money to a creditor. Ensuring the smooth flow of working capital is done by a company keeping track of the time lag between the receipt of payment from the debtors as well as payment of money to the creditors.
Any business where cash and goods are exchanged simultaneously must make sure that they have a favourable picture of the debtor as well as creditor days. These days can be upset by poorly-maintained revolving credit agreements, overly-generous credit terms which are enacted to boost sales, or the effects of problems related to the quality of the goods sold.
Any business worth their salt will ensure that they hire a team of accountants so that there isn’t any confusion concerning their debtors and creditors. Hiring accountants is a great way to ensure that your creditors and debtors are managed properly without devoting extra resources to managing them in the future.
Clear House Accountants are Accountants in London who recognize the hard work involved in understanding the various accounting and business terminologies involved in running a business. We have worked hard to create highly effective and concise guides and systems which will make this process easy for you, thereby helping you to understand complicated processes faster, enabling you to run and grow your business effectively. If you are looking for any advice or are stuck at some point in your business, please do not hesitate to contact us.
Author Bio
Jinesh is a Senior Business Accountant, with a masters in Finance from Westminster University, and specializes in tax and accounting for small to medium businesses with a turnover less than £ 3 Million.
He specialises in helping creative businesses understand and manage their accounting and tax needs and obligations.
As accounting ecosystems evolve, their potential to add value also grows. This has increased the focus on digital solutions to tackle complex business problems. Jinesh helps businesses see the opportunity in this and helps businesses become more efficient and increase performance, using the right solutions.
Some of the key things he focuses on are:
- Helping businesses gain insights from their business data
- Providing complex tax and accounting solutions
- Helping businesses prepare for complex industry developments and changes
James
Article well written. I was searching for some explanation and was really impressed with these details.
Thank you