Creditors and Debtors Explained
Creditors and Debtors might seem like simple terms, but the practicalities of applying the two terms can be confusing, and this is mostly the case if you’re a business owner. So, it’s important to understand the difference between the two terms; debtors and creditors.
We have explained debtors and creditors in the balance sheet in simple terminologies and detail, covering the contextual aspects of businesses.
What is a debtor?
At its most basic, debtors in a balance sheet usually owe money to another party. Who that party is can vary dramatically – It can be a single person, a big or small business, and even a government. If money is owed, the party that owes the money is known as the debtor.
In most cases, the loaned money is given in a lump sum. Repayments are then made over a predetermined period until the trade debtors pay off the loaned money. Usually, there will be interest for better business finances in addition to the loan’s value.
The incentive comes when the interest can be considered profit on the lent funds. It’s entirely possible to be a debtor and have debtors simultaneously, particularly as a small business.
What is a creditor?
Creditors in the balance sheet are a party lending 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, equipment. Creditors are of two types – loans and trade creditors and are generally composed of banks, building societies, and other financial institutions. The term “creditor” is not exclusive to any particular field or institution. However, there is a rising trend for alternatives, such as peer-to-peer lending. It’s 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 upfront or in one lump sum. Financing allows individuals or small businesses to use 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 late payment may result in further penalties and non-payment in potentially even legal action. The benefit for the creditor is that being able to make a loan is a 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. 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 payment terms with cash exchanging hands at later dates; this is called credit.
When a buyer and seller begin selling and purchasing products on credit, their relationship changes into a debtor and creditor relationship.
What is a debtor?
A debtor can be an entity, company or a person of a legal nature who owes money to another party. A business or a person with 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. Anyone to whom you as a business have to lend in any way, including unpaid invoices on products or services provided to clients, are considered as your trade debtors.
Why do businesses need to keep an eye on their debtors?
Businesses keep an eye on their debtors because managing their debtors in the right way ensures that they get paid faster, resulting in far fewer bad debts. In addition to this, collecting debtors’ accounts promptly ensure a healthy cash flow. Managing debtors are usually referred to as credit management and include 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 someone who has provided goods, money or services to a business or person with the expectation of being paid back at a future date.
A secured creditor is a creditor who has a registered lien on some of the businesses or person’s assets. In contrast, 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 company owes, how much the owed money, and when payments must be made or received lets businesses know their cash flow. It also ensures that companies have enough money in the bank for business payments, such as salaries, rent, and other overhead expenses.
As you can see, businesses need to keep an eye on their creditors, mainly if their companies 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 and the average number of days a company lets give before its creditors are paid, respectively.
Creditor days are used to measure a company’s creditworthiness and reputation to a certain degree. Creditor days determine the latitude allowed by its suppliers and creditors. It also reflects the value that both parties put on the business conducted and demonstrates the company’s cash flow and the extent that it’ll go to finance its business with its debt.
Debtor days are used to indicate how efficiently a company invoices goods, services and collects from its customers. Fewer debtor days are better for a company. Payment delays tell a company that their customers have cash flow issues or are facing problems. Due to their size and power, such as big supermarket chains, they might be overstocked or held to ransom by some of their customers. These types of customers usually fall victim to harsh credit terms and 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, while creditors have a credit balance to the firm.
- Payments or the owed money are received from debtors while loans 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 extended credit, while creditors offer discounts to the debtors to whom they are extending credit.
The main differences between debtors and creditors are as follows –
- Creditors extend the loan or credit to a person, organisation or firm. At the same time, debtors take the loan and, in return, have to pay back the money within a stipulated time with or without interest.
- Creditors can offer discounts to debtors, while debtors are the ones who receive discounts.
- Creditors are the parties to whom debtors should pay back.
- Debtors are mentioned under the category known as accounts receivable as a current asset, while creditors come under accounts payable as a current liability.
- No provision of doubtful debt is created for creditors, whereas doubtful debt is created for debtors.
Business transactions, at their simplest, have two parties involved: the creditor and the debtor. In short, a creditor is someone lending 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 and 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 and creditor days. These days can be upset by poorly-maintained revolving credit agreements, overly-generous credit terms enacted to boost sales, or the effects of problems related to the quality of the goods sold.
Any business owner worth their salt will ensure that they hire a team of accountants to avoid 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 recognise 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 that 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.