What Is The Meaning Of Debtor? – Debtor Meaning In Accounting

What is the meaning of debtor
| Updated on: March 4, 2022

Who is a debtor?

Business involves the lending of money or the extension of credit. This may not be a formal loan but a credit period that is allowed to a company or individual. The extension of credit is a very common business practice. The entity or person that extends the credit facility is called the creditor and the entity or person that owes money to the creditor is the debtor. It is essential for a business to manage its debtors well to stay financially healthy. Proper reporting on debtors is essential for decision making.

Ratio Analysis: How it Helps Determine A Company’s Financial Health

Bad Debts Expense: Definition, Example and Accounting Treatment

Understanding debtors

Every transaction that involves the lending of money has a debtor and a creditor. Transactions that involve creditors and debtors usually transfer some asset. They ideally end in the settlement of the money that is owed.

The manner in which a person or entity becomes a debtor or a creditor is through two means:

Money lending: When an entity lends money it becomes a creditor. Since there is always the risk of the money not being repaid, the creditor who lends money often requests a guarantee, collateral or some other means of security from the debtor. When the entity’s business operation itself is the lending of money this becomes a detailed and involved process. Banks, credit card companies, mortgage companies, auto finance companies are examples.

Extension of credit: When companies sell goods or services, they often extend credit to their customers. This is often for a short period of time and does not require any security, unlike a loan. The extension of credit is not the primary business or activity of the concern. However, the extension of credit and the timely collection of dues are important ancillary functions of the company. A company that does not extend credit may lose business to other competitors who do. A company that does not manage the collection of dues from debtors will soon be in great financial trouble. So, even if debtor management is not a primary function it is still a very important one. Manufacturing industries and supply chain companies are examples.

How does one become a debtor?

A person or entity becomes a debtor simply by owing money to another entity or person. So, if you are buying a product from a company and there is a credit period between your receipt of the product and the payment for it, you become a debtor till the due is cleared. Though you may not think of yourself as a debtor, you will be one until the dues that you or your company owe are settled. You also become a debtor when you take a financial loan from a person or entity. This could be an exception or the creditor may be in the business of providing loans to others. In simple words, if you owe money, you are a debtor.

Kinds of debtors

When you are the customer of a person or entity, you may at some point of time owe money to the supplier. So, though you may be referred to as a customer or a buyer, in accountancy you are referred to and treated as a debtor. The supplier is referred to as a creditor for accounting purposes.

When you take a loan from a person or financial institution, you may call yourself the borrower. The financial institution or person giving you the money may be called the lender. But, in accounting terms, the two parties involved will be referred to as creditor and debtor.

So, the two kinds of debtors are:

  • Customers who have availed of a credit facility from a seller or supplier of goods and services
  • Borrowers who have availed of a financial loan from a lender usually with security or collateral

The distinction between a debtor and a creditor

In the spoken language and general terms we refer to the parties to a transaction as the lender and borrower or the supplier and buyer. It is in accounting systems that the precise classification as creditor and debtor is made. It is very simple to understand who is a debtor and creditor by identifying the one who has given and the one who owes. The entity that has given by way of money or by the extension of credit is always the creditor. The entity that has received the money or who has been extended credit to is the debtor.

A bank that lends to an entity is the creditor. The person, company or entity that has availed of the loan from the bank is the debtor. A finance company that gives loans is the creditor and the entities that have taken the loan are the debtors.

When you order goods from a supplier who sends them to you after raising an invoice, the supplier is the creditor. Until you pay and clear the outstanding dues of the invoice, you are the debtor.

Examples of a debtor

As we saw above, the person or entity that owes money is a debtor. We can apply this logic to many real life examples to identify the creditor and debtor.

Credit Card: When you avail of a credit card you are essentially availing credit from the credit card issuing company. They are giving you credit that is equal to the card limit. When you use the card, you become a debtor as you owe the credit card issuing company money.

Employee Loan: Some companies allow their employees to avail of a loan facility. Instead of borrowing from financial institutions, the employee can take a loan from the employer which is then recovered from the salary. These loans are very advantageous as they are usually interest-free, quick and need no security from the borrower. The employer becomes the creditor and the employee who has availed the loan becomes the debtor.

Car Loan: when you buy a vehicle with a loan from an institution, you are the debtor and the financial institution is the creditor.

Mortgage: Mortgages are the most common form of loans that are taken by the common man. Most homes are purchased with a mortgage from a bank that is paid off over many years. The bank is the creditor and the homeowner becomes the debtor to the bank.

Trade: An industry may order its raw materials from many different suppliers. These supplies are usually made as per the agreement between the supplier and the industry. The supplier raises an invoice for the amount that is to be paid for the supply of goods or services that has been made. The debtor usually settles the amount within the time agreed upon in the agreement. This is a repetitive process as most industries need a continual supply of materials.

Importance of debtor management for business

Efficient money management is at the heart of business management at any scale. Debtors to a company are the entities from which money is due. The timely and efficient collection of these dues keep the money flow in the company at optimal levels. Any incompetence or mismanagement in debtor management will directly affect the bottomline of the company. Debtor management must also be interlinked with the overall accounting system so that the company's accounts are always up to date.

For a company that extends loans and overdrafts, debtor management is a daily activity. Mortgage companies, loan companies and other such entities have very detailed levels of debtor management. Debtors may be lent money at interest and with different terms and conditions. Debtors may make payments in repeated installments over a set period of time. If there are defaulters, the creditor may enforce penalties. Such companies need the right software tools to manage high volumes of debtors. An intelligent enterprise management solution such as Tally will allow the management of each debtor account efficiently. It will also bring all the company accounts together under a single solution for easy management as per accounting best practices.

Manufacturing and trade companies focus on their primary activities on a day to day basis. If they allow debtor management to slip they will find themselves in a cash crunch. Efficiency in debtor management helps them keep track of outstanding payments, the documentation involved as well and account for payments. Since debtor management is closely linked to inventory and supply chain management in these concerns, it is vital to use a software solution such as Tally to integrate the different aspects of accounting within the company. An integrated approach ensures that there is no necessity for repeated data entry. All the aspects of accounting are updated and in sync in real-time. When goods are supplied, the debtor account is automatically created for the amount. If there are quality issues, returns or any inventory transactions, the debtor account automatically reflects the changes. Tally is nimble and makes debtor management that is linked to inventory effortless to manage.

Good debtor management keeps the bottomline healthy and cash flows optimal.

Read more: 

TallyPrime

Looking for a solution to make your business more efficient?