By: Jinesh Jain Blog
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 the simplest possible way, covering the contextual aspects of businesses. Your business can be working with an accountant in London, in China, or anywhere in the world; debtors and creditors will have the same meaning, and this consistency in accounting is what makes comparing financial data globally very simple.
What is a debtor?
At its most basic, debtors in a balance sheet usually owe money to the business on whose balance sheet the debtors are being reflected. The debtor to a business can vary dramatically – It can be a single person, a big or small business, or even a government institution such as HMRC. If money is owed, the party that owes the money is known as the debtor on the balance sheet of the party that is owed the money.
The nature of the debtors can be different, they can be trade debtors, someone who has been given a service or product but has not yet paid for it, or it can be sundry debtors, general businesses, or individuals who can owe the business money for various reasons. Repayments are generally made over a predetermined period until the debtors pay off the trade debt or loan. Usually, there will be interest for better business finances in addition to the loan’s value.
A debtor who faces unexpected and unavoidable circ*mstances might be unable to repay their creditor. In such instances, they can potentially be exempt from liability. Poor management occurs when debtors, due to lack of knowledge or incompetence, fail to fulfill their financial obligations. Negligence involves engaging in fraudulent activities to deliberately become insolvent, avoiding debt repayment. Voluntary default is when debtors, despite having adequate resources, choose not to settle their debts.
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, or 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.
Pros 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 installments – 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’s 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 the potential for non-payment, forcing the creditor to pursue potentially expensive legal proceedings to get what they’re owed.
Debtors and 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 your trade debtor.
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 is usually referred to as credit management and includes the following –
- Timely debt collection
- Setting up credit limits as well as payment terms, a good acccounting firm should be able to help if you are uncertain on how to do this.
- Making credit checks as well as credit applications
- Enforcing a clear credit policy
- Considering debtor finance.
Read our invoicing process overview article to learn more on how to send correct invoices to avoid bad debt.
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?
Good Accounting services always have built-in controls and measures to make sure that the leverage a business has is under control, which is impacted the most by the liabilities a business has on its balance sheet. Creditors make up the largest part of the liabilities on its balance sheet. Businesses keep an eye on their creditors for this and many other reasons. Knowing how much a company owes, or how much is owed to the company, when payments must be made or received, helps businesses understand their cash flow. Cash flow is very important for the growth of a business. It ensures that companies have enough money in the bank for business payments, such as salaries, rent, and other overhead expenses. A 2016 report by the World Bank and IMF, shared by many London accountants with their clients, further reaffirms the importance of debtors and creditors and their correct management.
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 refer 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 to which it will go to finance its business with its debt.
Debtor days are used to indicate how efficiently a company invoices goods or 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 accounts receivable, while creditors are accounts payable.
- The term debtor comes from the word ‘debere’ in Latin, which means no owe, while the term creditor comes from the word ‘creditum’ in Latin, which means to loan.
- Discounts are offered to debtors by the person who extended credit, while creditors offer discounts to the debtors to whom they extend 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.
What is the Difference between Suppliers and Creditors?
The key distinction lies in the roles of suppliers and creditors. Suppliers primarily focus on delivering products necessary for a company’s daily operations, enabling it to manufacture and sell goods or provide services. On the other hand, creditors supply various resources, not limited to products. For example, electricity companies offer a service rather than physical goods, qualifying them as providers rather than creditors. The concept of credit involves legal obligations and is closely related to accounting terminology.
Conclusion
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 favorable 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 and 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.
Jinesh Jain
Senior Business Accountant
+44 (0)207 117 2639
info@chacc.co.uk
chacc.co.uk
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 of 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
