Debtors and creditors are central to how every business’ financial system operates.
They influence the amount of money flowing into and out of an account and the speed at which it arrives.
Understanding them and how they work in conjunction with each other is essential for businesses large and small. But the difference between the two can easily become confused.
So what is a debtor and what is a creditor?
Here we’ll simplify the two terms and explain how to effectively manage the debtors and creditors process to help your business’ bottom line thrive.
- What is a debtor?
- What is a creditor
- How debtors and creditors work together
- Setting up a debtors and creditors system
- How to handle bad debtors
What Is a Debtor?
In its simplest terms, a debtor is a party that owes money to another party.
On a personal level, it can describe a person who’s borrowed money from a friend and hasn’t paid it back yet.
In business, a debtor is an individual, business or any other entity that owes money to another entity because they’ve been provided with a service or product or borrowed money from an institution.
In every case, the debtor owes money and remains a debtor until they’ve paid the full amount back. They have responsibility for that specific debt.
There are two main types of debtor for all business owners to be aware of:
A company who takes out a bank loan will become a debtor to that bank. For example, if a digital agency agrees to borrow £10,000 to assist with setting up a new office, they’ll receive that money as a lump sum. Until it’s paid back, over a pre-agreed period of time and with interest, they’ll remain a debtor to the bank.
And a member of your team can be a debtor to your company if you agree to give them a staff loan. This is a loan given to an employee by an employer at a preferential rate that beats those offered by banks and building societies.
2. Trade debtors
A trade debtor is a customer or client who hasn’t yet paid you for your goods and services. They will remain a debtor until the invoice is paid.
Depending on the nature of your business and its financial set-up, it’s likely that you’ll have debtors and be a debtor yourself.
What Is a Creditor?
In its simplest terms, a creditor is a party that is owed money by another party.
On a personal level, it can describe a person who’s leant money to a friend and hasn’t had it paid it back yet.
In business, a creditor is an individual, business or any other entity that is owed money by another entity because they’ve provided a service or product or have loaned them money.
In every case, the creditor is owed money and remains a creditor until the full amount is paid back.
There are two types of creditor that, as a business owner, you’re likely to be dealing with:
Banks and other financial institutions are the most active creditors in any economy. By lending money to businesses, they support start-up and expansion plans with lump sums that are paid back over time, with interest.
Whether a traditional bank, peer-to-peer lending service or government scheme, they remain a creditor to an individual business until the loan is fully paid off.
2. Trade creditors
A trade creditor is an entity which has supplied a service or product and hasn’t yet been paid for it. For example, if a client hasn’t paid the final instalment of a payment plan for a new website project, the agency is a creditor to the client. This scenario means that your business would be a creditor to a debtor.
How Debtors and Creditors Work Together
In day-to-day business operations, debtors and creditors work hand-in-hand. The relationship they share reflects that of a customer and supplier, buying and selling goods and services on credit, and paying loan instalments on time.
The amount owed to a business will fluctuate alongside the amount it owes, affecting the assets and liabilities on your balance sheet.
Customers who don’t pay for products or services up front are debtors to your business, which serves as the creditor in this instance. Similarly, you are in debt to your suppliers if they’ve provided you with goods which you’re yet to pay for in full.
While being a creditor for another business can be considered an asset, demonstrating financial stability in your business, too much debt counts as a liability.
With careful management the discrepancy between the two reliably balances out to secure steady cash flow and future-proof your business. Get it wrong and the balance can tip towards potential failure.
Setting Up A Smooth Debtors and Creditors System
As a creditor, managing your debtors so you get paid on time is critical to your business’ survival. Mismanaging your debtors can jeopardise your ability to pay your own debts. The result? You risk becoming a bad debtor yourself – an unsustainable situation for any business.
To keep the cash flow cogs moving smoothly, you need to be in a secure financial position to pay suppliers and salaries, invest in growth and be a trusted debtor to your own creditors.
This requires devising and introducing a carefully planned process to increase the chances of being paid on time by your debtors. Here’s how to do it:
1. Get the right system in place
The right software will make managing debtors and creditors much easier. It will automate the entire process from converting quotes into jobs and jobs into invoices, to calculating cash flow for clarity and peace of mind.
It will let you set up templates per client, reducing the risk of human error, and give access to a dashboard to show you at a glance who’s paid and who hasn’t.
You can also check if an invoice has been viewed, which all helps when it comes to chasing late payments.
2. Establish clear payment terms
Deciding on specific payment terms is a personal choice based on the nature of your business. What is non-negotiable is making those terms explicit to your client.
Whether you opt for 7, 14 or 30 days, specifying the exact date by which an invoice must be paid sends a simple message: we politely expect you to pay us on time.
For some, setting the ‘standard’ 30-day terms is too much of a risk to cash flow and increases the chances of late payment. You could request cash on delivery, part-payment before a job begins or payment by instalment over the lifespan of a longer project.
You can also incentivise early payment by offering a discount and, at the other end of the scale, charge interest for late payments.
Whatever terms you decide on, don’t hide them in the small print and don’t be afraid to talk to your clients about them. Be bold!
3. Issue accurate invoices promptly
Clearly designed and presented invoices will make life easier for everyone. Making them detailed and transparent will decrease the chances of customer quibbles and increase the chances of getting paid accurately and on time.
And issuing them promptly will showcase your business as a slick and professional operation.
A typical comprehensive invoice needs to include the following:
- A clear title indicating that it’s an invoice.
- A unique number to act as both the seller’s and buyer’s reference.
- The names and contact details of both the seller and the buyer. Email addresses are essential. It’s also wise to include a postal address in case any important documents need to be physically posted. All these details should be carefully checked for accuracy.
- The date of the invoice. This is crucial as it starts the countdown to when the invoice needs to be paid.
- The date the product was delivered or the service was supplied.
- Details of what items have been provided, including prices (per item or per hour) and quantities (of product or, for services, time).
- The total amount charged, including a breakdown of VAT and delivery charges if relevant, and any discounts already applied.
- The payment terms including how to pay, what methods are accepted, when payment is due, and details of late payment terms and early payment discounts.
- References to previous document numbers related to the sale, where relevant.
- Your business logo to raise brand awareness and establish professionalism.
- A space for a personal note if required.
4. Send out reminders
Going back to being bold, don’t shy away from sending out reminders. A polite but firm email the day before an invoice is due will act as a gentle nudge.
Make sure you have a failsafe system to do this: incorporate reminders into your accounting software templates. And if the initial email doesn’t get the required response, don’t put off picking up the phone. A quick chat may be all that’s needed to resolve a query.
5. Make it easy to get paid
A crucial element of a successful invoice is pinpointing how you can be paid, whether that’s by credit card, Direct Debit or an online payment. Offer a variety of options to please your clients without overloading your admin to-do list.
For example, if you offer Direct Debit for regular payments, your creditors will easily be able to integrate it into software such as Sage and Xero, as will you, saving time and hassle.
6. Build strong relationships
An important part of managing debtors and creditors is to maintain professional business relationships with clients and suppliers. Whether you owe money or are owed money, being proactive and keeping the lines of communication open are the best routes to positive cash flow for all.
If you’re faced with late payers or are struggling to pay a debt, never let the issue become emotional or personal. Deal with it legally, ethically and calmly and you’re more likely to secure a happy ending.
How To Handle Bad Debtors
No business is immune to overdue invoices. Regardless of how efficient your system and how diligent your approach, your debtor list is unlikely to ever be zero. Step forward a dependable late payment strategy.
Right from the start of any agreement with a client, ensure you keep a record of all communications. Your accounts software will do this for you: the modern version of a paper trail.
You then have a small window of opportunity to give the benefit of the doubt: the invoice could have been unintentionally overlooked and all that’s needed is a gentle prompt.
If you suspect your debtor has cash flow challenges, give them the chance to explain and commit to a revised deadline date. They have no intention of reneging on the debt but currently cannot pay it. The ball is in your court to agree revised terms, advisably in writing.
Similarly, if as a debtor you find your own business unable to meet a creditor’s payment terms, be honest and professional. Informing them of the temporary difficulty and agreeing a new payment plan can easily avoid later legal complications.
All businesses are entitled to start charging interest on an unpaid debt. This statutory interest is charged at 8% plus the Bank of England’s base rate, the threat of which can often be enough to trigger action.
And if a payment has still not materialised, you can pursue a debt of £10,000 or less via a mediation service or at a small claims court. This will no doubt bring an end to the business relationship but should get the money in your pocket and free you of dealing with them again.
To recap, all business transactions involve two parties, a debtor who owes money to a business and a creditor who is owed money by another entity.
Now you know the answer to the question ‘What is a debtor?’ and understand their relationship to creditors, you can use your knowledge to inform and improve your credit control system.
Keeping a close eye on the ebb and flow of payments from debtors and payments to creditors will ensure a smooth flow of working capital.
And working to minimise late payees, reducing the length of your debtors’ list, will help to boost positive business performance. You’re then all set to be a dependable debtor and professional creditor.