The Main Difference Between Debtors and Creditors
Another way to consider debtors and creditors is to observe the directional flow of money. Debtors are people who owe the company money, so debtor money would flow into the company as the debtor pays back the money owed. Creditors are people who extend lines of credit to the company, so creditor money would flow OUT of the business to pay back the loan. Debtors and creditors can be either an individual or a company.
In general, a debtor is an individual, a nation, or a company that owes money, But in the context of business, a debtor is not only someone who may owe a one-off debt, but also a person who is extended a line of credit by the company. (Source: Corporate Finance Institute)
For example, a vendor of car parts may allow auto shops that buy through them to hold a charge account. The auto shops would be considered debtors to the cart parts vendor because they owe them money.
Many companies that act as vendors to either individuals or companies may keep a running account of debts for all of their regular customers. The sheer number of transactions involved in debtor accounts makes keeping the books difficult for companies with a large customer base. This is one of the driving motivations for companies to hire permanent bookkeepers.
What Is a Debtor?
Debtors have existed for since human existence, but in the context of finance, a debtor is important because they have a direct impact on cash flow. Companies that are unable to collect their debts end up with their own payment issues to their creditors.
For companies that operate as a vendor, one of the most common ways of being paid by debtors is through what is known as a net-30 term.
This is an invoice agreement that states the debtor has 30 days from the date of receiving their invoice to pay the amount owed. For vendors that do amounts of business with a company throughout the week, it is easier to let them “rack up a tab” than to get paid in individual transactions.
Here are the main traits that differentiate a debtor from a creditor in business:
- Debtors are considered accounts receivable. This means in a business ledger, debtors will be listed in the section where the money is coming into the company, rather than out of it.
- On a balance sheet financial statement, debtors are listed among the assets of a company since they represent money that the company “owns”.
- Debts can be one of the hardest categories of a company’s assets to liquidate quickly since they are usually bound up in 30-day contracts and are susceptible to non-payment.
For some companies, debtors may not play a huge role in the daily workings of the business. But in others, debtors make up the bulk of a company’s incoming cash flow.
What Is a Creditor?
In business, a creditor is any entity (a person, a nation, or a company) that offers cash or other assets out on a line of credit to another individual, nation, or company. There are two major types of credit used in business around the world (Source: Investopedia):
- Secured credit: Secured credit is a line of credit that is backed up with collateral, or property in the value of the amount that a person is borrowing. For example, if a person takes out a secured line of credit using their car as collateral, that car can be repossessed by the creditor if the debt isn’t paid in a timely fashion.
- Unsecured credit: Unsecured credit is a line of credit that isn’t backed up with collateral, which means the creditor assumes a larger degree of risk in offering it out. Unpaid debts that are part of an unsecured credit line are pursued through a process called collections. If the debtor does not pay off their debt, the creditor can report them to credit companies and lower their score.
Credit is such a large part of business that there are entire companies dedicated to the business of consolidating credit and buying the debts of others. In many cases, a company will eventually sell their debt off at a loss to a third-party collections company, who will then pursue the debtor for the amount that is owed. This is a financial practice known as debt factoring. (Source: Velotrade)
Managing Finance as a Debtor
When a company is a debtor to a creditor, managing cash flow carefully is important. Without adequate cash flow into the company, a business will not have the capital to pay off its debts. This can cause vendors to halt services or can even cause the business itself to be closed or sold.
Failing to keep debts balanced in proportion to incoming assets is one of the top reasons that companies go under. Here are just a few of the steps that companies can take to manage their finances when they are acting as a debtor to others (Source: NFCC):
- Keeping a crystal-clear general ledger. Ledgers of outstanding debts should be recorded with all pertinent information such as the monthly payment, interest rate, due dates, and total amount due. Keeping a record of all these debts in one place in the ledger can allow a business owner, office manager, or bookkeeper to easily see how much debt the company is in.
- Analyze the books. When assessing debt, it’s important to look not just at a company’s past performance, but also at the way it is projected to perform in the future based on current events and other financial factors. An accountant is the best person to ask for advice in this regard. Analyzing debt allows a company to see if they’re treading water or actively sinking.
- Reverse cash flow. The main issue with increasing debt as a company comes when you don’t have income that outpaces it. To reduce the accumulation of financial debt, operating costs have to be reduced and resources stripped down, while sales need to increase. This will tip the scales back in the favor of the debtor so that they can start getting bills caught up.
- Negotiate contracts. Many of the third-party contracts that a business sets up with vendors from water cooler replacement to building cleaning can be negotiated with for a discount on services if a company has been using them for a long time. If not, business owners should do some comparison shopping to see if they can get the same services cheaper elsewhere.
Learning how to manage debt as a business is one of the best indicators for a company’s success. Because of how much they have to extend themselves, almost all businesses run in some form of credit, even if it’s just a business credit card held by the business owner. The delicate balance between money coming in and money going out can be make-or-break for any company.
Managing Finance as a Creditor
Along with taking credit from others in the form of 30-day net vendor services or open loans, businesses also often find themselves managing finance in the role of a creditor. Whether this is managing invoices on 30-day accounts or offering lines of credit themselves, most businesses find people owing them money just as often as they owe others.
Extending customers credit can be a great way for businesses to develop a stable pool of steady income as long as the customers in question stay paid up. But extending credit as a creditor can also leave people and businesses hung out to dry if they aren’t careful. Here are some practices people and companies should adhere to for success when acting as a creditor (Source: Small Biz Trends):
- Figure out who owes you money. People who have credit with an individual or company usually fall into a few categories: people who don’t want to pay, people who temporarily can’t pay, and people who are like clockwork about paying their bills on time. Figuring out a percentage of bad debts to good debts in the ledger can give business owners an idea of how stable they are.
- Keep the temperature cool. It’s easy to get emotionally wound up when trying to collect debts as a creditor, especially if you’re a small business owner and you feel like you’re getting taken advantage of. But letting your emotions get in the way of your judgment won’t do you any favors. Don’t carry on emotional upset from one collection call to the next.
- Know your rights as a debt collector. It’s important when collecting debt to know how far you can push before you push into the area of harassment, and it’s also important to know what your options for collections are if you have a debtor who refuses to pay up. The rules and regulations with regard to debt collection are different for every region.
- Keep good documentation. When you’re trying to collect debts, documenting your attempts to collect the debt and keeping updated records of the money you’re owed (including any payments made towards the final amount) can help you keep things straight and avoid miscommunications. It is bad business to accuse someone of owing more than they do.
- Know when to cut your losses. In some cases, the resources or money necessary to pursue a debt start to become pricier than the amount of the debt itself. There can be a lot of waste in pursuing bad debts, so knowing when to write a debtor off is an important part of learning how to manage a business. Having enough capital to cover these losses is also important.
Some people can be uncomfortable in the role of a creditor to others. Nobody wants to be put in a position where they have to nag someone else to get paid. But being aware of how extending credit works and how to resolve conflicts with unpaid debts is an important part of running a larger company.
When a company gets into financial trouble as a result of the money that is owed to them, this debt can be sold to a third-party debt collector. While it is unlikely that the original owners of the debt are going to get back all of their assets as a creditor when they surrender their debtors to a collections agency, they can at least recoup some of their losses this way.
Advantages for Businesses in Acting as a Creditor
Even though there are difficulties associated with collecting debts as a creditor from individuals or other companies, there are also some major benefits to be had for businesses that have enough working capital to extend lines of credit to their customers.
Here are just a few of the advantages of being a creditor as a business (Source: Apurve):
- Increased sales: Many customers are willing to jump ship from a company that forces them to pay upon purchase to one that will allow them to defer payment from anywhere up to 30 or 60 days, so implementing a credit program in business is a good way to help drum up new customers if current sales figures are stagnant.
- Increased customer loyalty: Repeat business is one of the biggest drivers of company success, and offering customers generous payment terms is one way to help encourage loyalty in your customer base. Extending credit to customers offers them a sense that the company trusts them, and this encourages the customer to like and trust the company in turn.
- Ammunition for negotiations: Being able to extend credit to other companies is a good way to skew the agreements of a mutual contract in your favor. By doing so, a company can get the most out of its business deals. Being stuck in a position where you aren’t able to counter-offer with amended payment terms puts businesses at a disadvantage in contracts.
- Contracting work: Government agencies like to work with businesses that offer them the most beneficial payment agreements possible, so for those companies who wish to pursue contracts with the government, having some ability to extend credit is crucial. In many cases, government funding may have to go through several hoops for approval too, which can slow payment.
- Signal to competitors: Showing competitors that you’re willing to extend credit projects a business model that is flush with cash, and in cutthroat markets, projecting this level of business confidence is half the battle. Getting a company to the point that they don’t have to worry about collecting every dollar on the spot is a good indicator of financial health.
While it might take businesses a bit of expansion to get to the point where they can safely offer extended payment options, it’s always a good goal to consider. Reaching this milestone as a business can be a jumping-off point for some serious growth in the company’s profits. The ability to extend and collect on credit also reflects well in a company’s business credit score.
Disadvantages for Businesses in Acting as a Creditor
Acting as a creditor in business can be a useful bargaining chip, but it can also potentially leave the business vulnerable. It also requires business owners and office managers who are strong enough to stand up to non-paying customers. These are some of the drawbacks of offering credit as a business:
- Collections: Nothing raises an office manager, business owner, or bookkeeper’s blood pressure quicker than having to spend time on the telephone playing phone tag with people that owe their company money. Depending on how trustworthy your customer base is, the time put into collecting debts that will never be collected on isn’t worth the trouble of chasing them.
- Missed payments: Missed payments here or there may not be a huge deal depending on how much capital a company is working with, especially if they have late fees or some other mitigating term in place. But missed payments can also snowball into a serious issue with cash flow if past due accounts are left unresolved too long.
- Legal trouble: By offering credit to someone without getting payment upfront for services and products, business owners and companies open themselves up to being forced to sue to get their money back in some cases. This can create significant expense and stress for the owner of the company, and can also negatively affect morale.
- More complicated records: Keeping track of 30-net accounts receivable invoices is more complex than just handling direct sales transactions. Not only do bookkeepers or business owners have to keep up with the current debt, they also have to factor in things like late fees or interest charges. This can make the accounting side of business much more tedious.
- Cash flow: Extending credit might be a good way to drive up the number of customers a company has, but it’s also a good way to decrease the amount of cash flow coming into a business since it restricts payments to certain times of the month. A rash of unpaid accounts can also set up businesses for a serious misbalance between cash flowing in and cash flowing out.
Juggling credit in a company isn’t simple, and there are just as many things to warn a business owner off of it as there are advantages. That’s why acting as a creditor needs to be done carefully to avoid legal and financial problems.
For small business owners, it is easy to fall into the habit of being sympathetic with sporadically paying customers, especially if they have a touching sob story about why they can’t pay their invoice.
Small business owners often have direct contact with vendor representatives, so they may find it hard to rock the boat with a person they do so much business with. However, as with many things in life, setting healthy boundaries is important from the get-go to avoid trouble. That goes for extending credit as well as taking it out.
Advantages for Businesses in Acting as a Debtor
It might not seem like a good business practice to be in debt, but when managed skillfully, a business acting as a debtor can make some sound financial decisions that benefit the company rather than weaken it.
Here are some of the advantages of being a debtor as a business (Source: Business Articles Hub):
- Executive power: Taking on investors in a business means that even though you’re getting extended capital in return, you now have to factor in the decisions of others into the overall business plan. Taking a loan in comparison leaves the business owner to act as a sole proprietor if they wish.
- Easy access: For most small business owners, business loans and other lines of credit are fairly easy to establish as long as you don’t have a bankruptcy or other history of bad credit. This makes a business loan perfect for getting a new business off the ground without a lot of start-up investment capital.
- Good interest: There are many business loans available with favorable interest rates that work in the company’s favor. These are usually put into place to help encourage entrepreneurs to start companies with minimal personal financial risk. Interest rates will vary from loan to loan and depend on the creditor extending the loan.
- No shared profits: Investment is another popular way of taking new capital into a company for expansion, but with investment comes a divided shareholder’s equity. Getting a loan rather than going through investors can help concentrate profits for a sole proprietor or someone who wants to limit the number of owners involved.
It might seem risky for a business to put itself into debt, especially right at the beginning of its setup, many people require business loans to get their small businesses off the ground. Even larger corporations require business loans for expansion or to keep themselves afloat when they’re in the red financially.
Disadvantages for Businesses in Acting as a Debtor
Most businesses are made to depend on credit at some point or another, and this can usually help a business in the short-term. But the longer-term consequences of extending a business on credit, whether it’s secured or unsecured, can come back to bite a business if their debts and loans aren’t handled correctly.
Here are some reasons why taking out a line of credit can work as a disadvantage for a business (Source: Insights for Professionals):
- Increased risk: Taking investments from shareholders is a way to increase the capital of a business at minimal risk, but it also diffuses profits. Taking out a loan allows a business owner the opportunity to do well if they’re able to profit and pay the loan back, but it also brings the risk of debt collapsing the company.
- Decreased credit score: Having loans out can decrease a person’s credit score, especially if there are any missed payments on those loans at all. This can make it even more difficult for a business to secure loans in the future. On the flip side of that, carrying no lines of credit at all can also reflect poorly on a person or a company’s credit history.
- Loss of collateral: In many cases, business loans are secured loans. This means they’re backed up by company assets that act as collateral such as property, buildings, equipment, or other products. If a company does not pay back their business loan, the bank or credit company can foreclose on that collateral and take it. This is a serious threat that can cause business failure.
- Interest fluctuation: Interest rates for business loans fluctuate from fiscal period to fiscal period, and a business loan that a business takes out at a reasonable rate may skyrocket if the company ends up carrying the loan too long.
- Bankruptcy: Defaulting on a business loan or filing bankruptcy can cause serious problems for business owners looking to secure lines of credit moving forward. A company bankruptcy also reflects poor business practices to potential investors, which also makes it difficult for owners to get a failed company back off the ground.
Securing a business loan or other lines of credit is often impossible to avoid for companies as they expand and invest in new growth opportunities. However, taking on debt is always a gamble for any business without very stable performance on the market.
Debtors and Creditors Have a Lot of Overlap
Even though debtors and creditors are on opposite sides of the finance spectrum, there are many cases where individuals and businesses are required to be a little bit of both. Despite their differences, these concepts share a lot of the same advantages and disadvantages for a growing company with regards to cash flow and the general difficulty of business operation.