12 Debtors and creditors

Need to know

Why is this important?

Debtors are an important source of future cash inflows. They enable a business to predict with some degree of certainty the cash that will be received in the following days and weeks.

However, debtors are not yet cash and cannot be used to fund immediate cash demands faced by a business.

Creditors, on the other hand, may be an important source of short-term business finance. Paying suppliers later, rather than earlier, means that cash is available within the business for longer. If the period of credit offered by suppliers correlates to the period of credit offered to customers, it will help an organisation manage its cash flow.

Debtors and creditors form part of a business’s working capital. The other main component of working capital is stock (see Chapter 11 Stock and Chapter 24 Working capital and liquidity management).

When is this important?

The management of debtors and creditors is a continuous task for the majority of businesses. Managing the timing of cash inflows and cash outflows is essential for a business to survive. It is important to monitor regularly and sometimes remind debtors that their payment is due (see Credit control below).

In practice

Businesses invest sizable resources, particularly into managing debtors. Examples of typical management tools are:

Nice to know

Alternative terminology

There are several interchangeable terms for debtors and creditors. This chapter uses ‘debtors’ and ‘creditors’ as these are the most widely used and known in practice.

Credit control procedures

To collect cash from customers it is important to follow procedures and be organised in collecting customer debts. The following steps should be followed, where applicable:

Managing debtors

• ■Debt factoring
• This is where a business outsources the collection of debt to a third party, who has specific expertise in managing and collecting debts. Debt factoring has some advantages (for example, freeing staff to concentrate on running the business, strong credit control procedures and cash advances (at a discount) issued by some factoring companies). It does also have some consequential disadvantages (for example loss of contact with customers and reliance on the factoring company). (See also Chapter 24 Working capital and liquidity management.)
• ■Invoice factoring
• Useful for cash advances on specific high-value invoices, as opposed to debt factoring all customer debts.
• ■Insurance
• For a premium it is possible to insure against certain risky debts. This is useful for exporters.
• ■Sale of debts
• There are specialist debt collection companies who will purchase debtor balances and even bad debts (see below) from organisations. However, they will only pay a proportion of the amount the debtors owe for such debts.
• ■Offering discounts
• Some businesses offer discounts to incentivise early payment. The cost/benefit of discounts should be carefully considered. Often the cost of a discount can be more expensive than the cost of finance relating to the delay in receiving monies from customers. Additionally, some customers will take the discount despite not paying early.

Bad debts

Bad debts are a fact of life for many businesses. Many companies will have a bad debt provision (see Chapter 14 Provisions and contingencies) in their accounts made up of two elements:

• 1A specific bad debt provision:
  • ■This is for specific known debtors. For example, those which have become insolvent or where there is a potentially unresolvable dispute.
• 2A general bad debt provision:
  • ■Through experience the business typically suffers a number of unanticipated bad debts for a variety of reasons. A general bad debt provision is set, typically as a percentage of the overall debtors’ balance to reflect this, for example 2%.

Debtors are quoted net of bad debt provisions in a company’s balance sheet.

Managing suppliers

It is also important to manage supplier payments.

Suppliers are not only an important source of credit; they are also essential to the success of a business as they often provide the key inputs. While it is acceptable to ask for credit from suppliers, it is important not to abuse their goodwill. Healthy supplier relationships are important to ensure continued future supply.

Accounting systems will produce aged supplier listings which enable payments to be planned and scheduled (see Chapter 2 Finance personnel and systems). This should be integrated into a cash flow forecast to ensure sufficient funds are available to meet payment deadlines. Most businesses will take full advantage of the credit offered by suppliers (see Chapter 24 Working capital and liquidity management).

It is often a question of relative ‘power’, which dictates who determines payment terms, which is why many businesses prefer to do business with similar-sized partners.

Optional detail

Debtor and creditor days

Debtor and creditor days can be calculated by using the following formulas:

$\text{Debtor collection period}=\frac{\text{Debtors}}{\text{Sales*}}\times \text{365}$

* ideally only credit sales should be used as the denominator.

$\text{Creditor payment period}=\frac{\text{Creditors}}{\text{Cost of sales**}}\times \text{365}$

** ideally only credit purchases should be used as the denominator.

(See Chapter 24 Working capital and liquidity management).

The debit and credit confusion

The terms ‘debtors’ and ‘creditors’ are derived from the terms ‘debits’ and ‘credits’. For a business, debtors are debits and creditors are credits. Debits and credits are part of the system of double entry bookkeeping underpinning accounting.

Confusion sometimes arises because retail banks use the terms debit and credit from their own perspective (as opposed to their customers’ perspective). The prevalence of these terms used by banks has confused their meaning for many people their meaning for many people.

For example, consider how bank balances are seen by both businesses and banks:

Therefore, it is important to consider perspective when looking at debtors / debits and creditors / credits.

Reflect and embed your understanding

• 1For an example organisation, reflect on your expectations of ‘creditor days’ and ‘debtor days’ then calculate their debtor days and creditor days. Is the actual result in line with your expectations? How can you explain the difference?
• 2Will debtor days always correlate with creditor days? If so why? If not, why not?
• 3Is debt factoring a good idea or should it be considered only as a last resort? Which businesses do you think are more likely to resort to debt factoring?
• 4Reflect on why the practice of offering credit to customers and suppliers has become the norm. What do you think would be the implications, practical or otherwise, of changing to a ‘cash on delivery’ basis of trade?
• 5Which credit control procedures are most effective in collecting debts?
• 6When should a business take supplier credit?

For the authors reflections on these questions please go to financebook.co.uk

Where to spot in company accounts

Debtors and creditors can be found on the face of the balance sheet under current assets and current liabilities respectively.

Extract from Greggs plc 2020 annual report and accounts

Debtors are included under the heading ‘Trade and other receivables’ on Greggs plc’s balance sheet, which is supported by note 16.

There is also an analysis of the ageing of trade receivables within note 16.

Creditors are included under the heading ‘Trade and other payables’ on Greggs plc’s balance sheet, which is supported by note 18. An extract follows:

(Appendix pp. 471, 472)

Consolidate and apply

To see how the concepts covered in this chapter have been applied within Greggs plc, review Chapter 36, p. 393.

Watch out for in practice

• →Review the value of both debtors and creditors over time to assess if they are moving in line with the growth or decline of the business.
• →It is useful to analyse debtor days over time. This gives an indication of a business’s exposure to debtors. It is also a reflection of credit control and any change in practice.
• →Similarly, it is useful to analyse creditor days over time. This gives an indication of a business’s reliance on suppliers’ credit. It is also a reflection of any change in practice.
• →As part of analysing working capital (see Chapter 24 Working capital and liquidity management), it is useful to compare the level of debtors compared to the level of creditors as a quick and simple measure of a business’s liquidity exposure.
• →Transactions around the year end, either sales, receipts, purchases or payments, may result in a distortion of year-end balances of either debtors or creditors and in turn profit.