To better your company's financial standing, you must develop a strong understanding of accounting fundamentals and terminology. After all, this will empower you to make smart decisions that take your business from strength to strength.
This article will help you to gain a deeper understanding of what a debtor is and what a creditor is, alongside exploring the role a debtor and creditors play in your financial management. It will also touch upon the consequences of having too much bad debt and the steps you can take to manage and prevent this in the future.
What is a creditor and a debtor?
A creditor is a person or entity that lends money to another party. The debtor is the person who owes money to another person or entity.
Generally, creditors can be banks, credit card companies, credit unions, mortgage lenders, financial institutions, loan officers, businesses or individuals. Debtors can be any party that borrows or agrees to pay for a service. Debtors and creditors can also be explained in more general terms. For example, if you give a loan to family members, you are the creditor, and the family member (borrower) is the debtor.
There are two primary types of creditors: loan creditors and trade creditors. Loan creditors are creditors who lend money that must be repaid with interest, such as financial institutions that provide you with personal loans. Trade creditors are suppliers who are extending credit to customers to purchase goods or services. As such, your business is likely classified as a trade creditor.
If you were to take out a loan agreement from the bank or another financial institution, the bank would become your creditor while you assume the role of the debtor. After all, in this scenario, you're the party asking to borrow from banks.
What are the consequences of having a lot of creditors?
While you may need to borrow money reasonably often, having a lot of creditors could make it difficult to keep track of who you owe money to or to make repayments. This lack of clarity can lead to missed payments, which not only damage your relationship with the financial institution/person lending money but could also damage your credit scores and bottom line.
Having a lot of creditors could also mean you are unlikely to get approved for future business loans or lines of credit, as you'll be classified as a high-risk borrower. For example, other financial institutions may begin to doubt your ability to pay back loaned money, even when using credit cards.
How to manage your business's creditors
As evidenced above, managing your creditors can be challenging, especially if your business borrows money quite often. However, there are certain steps you can follow to make borrowing money easier.
Set up a system for tracking creditors payments
The most effective way to manage your creditors is to set up a system for tracking payments. This ensures that you remain organised and fiscally responsible and can help you avoid missed or late payments. In short, it ensures borrowed money is returned to the financial institution or lender.
This way, you can reduce the interest you pay on owed money and maintain positive relationships with your personal creditor or the party that lends money. You can ensure bills are paid promptly by using tools like automatic bill.
Simply put, when borrowing money, you must keep track of who you owe money to and when payments are due. This will help you to manage your budget accordingly and avoid the hassle and legal implications of dealing with debts collectors.
Negotiate Fair Payment Terms
Another way to manage your creditors is to ensure that you negotiate fair payment terms ahead of time. For example, if you are going to pay interest on your loan, you must know the rate that will be applied to your original loan. You should also develop a payment schedule that reduces your financial burden so that you're paying your loan back in smaller instalments instead of a lump sum.
If possible, within your loan terms, consider consolidating debts into a single loan agreement - preferably one with a lower rate.
Communicate with your creditors
If you are having trouble making a payment, you must communicate this with your creditor. After all, there are many reasons why you may be struggling financially, especially in the current climate, and creditors typically are responsive to those asking to re-negotiate their terms. For example, they may agree to lower your interest rate or create a more fitting payment plan.
Prioritise high-interest rate creditors first
While managing repayments to multiple creditors can be challenging, it's typically advised that debtors prioritise repaying high-interest-rate creditors first. After all, this will reduce the amount of money debtors owe overall, as you're not giving the interest rate any time to grow.
Consider credit counselling
If you are consistently struggling to manage your creditors, it's important to note that many organisations can help. For example, credit counselling services can help with budgeting or negotiating with creditors on your behalf. Some non-profit organisations or credit unions also offer debt management programs for when a debtor fails to make a repayment.
What is a debtor?
As mentioned previously, a debtor refers to both individuals and entities who owe money to someone else. In the example outlined above, you were the debtor because you owed money to another party (the bank).
However, in the business world, the term debtors refers to customers who owe money to a company. This could include individuals, companies, and other entities.
While the name may indicate otherwise, being a debtor does not necessarily imply that the person or entity paid late; rather, it signifies that they have borrowed money or incurred a debt that needs to be paid. It could just mean they have an outstanding invoice.
For instance, people and companies frequently borrow money from other companies and make payments according to their agreed-upon terms. As such, many debtors repay their loans or credit card balances without any cause for concern. Therefore, it's essential to understand that customers can also be considered debtors, even if they make timely, prompt payments.
What are the consequences of having a lot of debtors?
Though having debtors is an inherently common occurrence within the business world, having a significant number of debtors can pose its own challenges. For example, it becomes problematic when debtors consistently exceed their payment terms and pay late, meaning you cannot collect money owed to your business.
Having a significant amount of debtors often indicates that a substantial amount of money is owed to your business, which could strain cash flow. This, in turn, can hinder your ability to meet your own financial obligations, such as paying suppliers, covering operating expenses, investing in growth opportunities, or even making your own repayments.
If you are constantly chasing after debtors to reclaim the money you are owed, this can also place a significant drain on your time and resources. After all, it means that your team is spending more time chasing payments and less on the roles you actually hired them for, impacting productivity and overall efficiency.
While you can make debtors pay interest on late payments, there are some scenarios in which you may need to take legal action. While this ensures that you are paid by the debtor, it can be a time-consuming and costly process within itself.
Therefore, it is crucial that you closely monitor and manage their debtor accounts. This ensures that repayments are made on time and in accordance with agreed-upon terms. This proactive approach will improve the financial stability and sustainability of your business by helping you to maintain a healthy cash flow.
How to manage your business's debtors
There are several things that businesses can do to manage their debtors.
Have a clear credit policy in place
To begin with, you should ensure that you have a clear and concise credit policy in place. This should clearly outline the terms you are prepared to extend credit to customers and the consequences of failing to make timely payments.
Run credit checks on debtors
Knowing your customer's credit history can also play a crucial role in managing your debtor and creditor relationship. As such, you should conduct regular credit checks on new and existing customers. Knowing their credit scores means you can identify high-risk debtors (a debtor who is likely to default on a payment).
In addition to learning more about their credit scores you should also closely monitor their payment history or patterns. This way, if a debtor begins to fall behind on payments, you can take action to try and recover the debt before it gets out of hand.
Segmenting your customers into different risk categories can also be helpful. This means that you can tailor your approach to chasing payments depending on the level of risk involved.
Work with debt collectors
If you are struggling to recover debts from customers, there are many specialist debts collection agencies that can help both debtors and creditors. Though debt collectors agencies usually charge a fee for their services, it's worth it if you can recover the money the debtors owe your business.
What is bad debt?
Bad debt refers to a situation where a customer (debtor) owes money to a business (creditor), but it's unlikely that the business will be unable to recover the outstanding amount. There are many reasons why this money may be considered lost, but it often boils down to the debtor's inability to make a payment.
In these scenarios, you must take proactive measures to recover the debt from the borrower promptly. After all, simply allowing the debt to accumulate will have a detrimental effect on the financial health of your business.
Fortunately, there are several approaches a creditor can take when trying to recover bad debt, with the most common method being the utilisation of a debt collection agency.
However, another avenue for debt recovery involves pursuing legal action. Though this course of action can be both expensive and time-consuming, there are instances where it becomes necessary to reclaim the owed funds, and federal regulations will work in your favour.
It's also worth noting that the key to preventing bad debt in the first place is preferable to dealing with its consequences. This can be achieved by:
- Implementing effective credit control measures
- Conducting thorough background checks on customers
- Setting clear payment terms and negotiating as necessary
- Sending payment reminders and prompts to a debtor
- Maintaining open communication channels with customers/clients to avoid escalation
How to avoid bad debt
The good news is that there are a number of things you can do to avoid bad debt, without needing to use your credit cards. Including:
Credit check your customers/debtors
One of the most important things you can do is to screen your customers carefully, especially if you are working with them for the first time. This typically means performing a credit check on new customers so you know that they can pay their bills. However, you should also assess the creditworthiness of your pre-existing customers too. This will help you to identify issues before they present themselves.
Offer payment terms or loan terms to debtors
While you should make an effort to establish fair debt collection practices, you can drastically reduce the risk of bad debt by ensuring that you offer payment terms that best suit your business. For example, you could encourage customers to pay quickly by offering a discount for early payment or asking for a deposit upfront.
Change your invoicing process
The way you invoice for your goods or services can also impact the likelihood of getting paid on time by a debtor. Many businesses make the mistake of sending out invoices too late, which could explain why 87% of businesses report that their invoices aren't paid on time. Delayed invoicing gives customers time to forget about the bill or put off paying it.
As such, you should set up a system where borrowers/debtors are automatically invoiced as soon as the work is done.
Be proactive about chasing payments
It's also important to be proactive about chasing payment when debtors owe money. Fortunately, if you have a good debtors and creditors relationship with your customers, they may be more willing to work with you to find a solution.
Have clear terms and conditions
Setting up clear payment terms and conditions and sending out clear invoices will make it easier for you to get the money you deserve from debtors. It means the debtor knows precisely when to pay and what will happen if they do not.
Call on the experts
If debtors are screening your calls, emails, and requests for invoice payments, it's time to call for outside help; you may want to outsource this task to a debt collection agency.
However, choosing a debt collection service that prioritises mediation over aggression is preferential, as this will result in a happier outcome for both a creditor and a debtor.
How Chaser can help
As experts in credit control, Chaser can help you to get paid on time, every time.
Chaser's team will work with you to understand your business and then tailor our services to suit your needs - whether that's offering our credit control software so that you can automate the accounts receivable process or acting as your debt collector and helping you get your old, bad debt paid from customers and other entities.
