Money is the backbone of all business operations. Every company runs because they have both the outflow and inflow of money. We can see that all businesses are creditors and debtors to some other businesses in our society. These creditors and debtors play a vital role in shaping a company’s work and positioning in the market.
In this section, we are discussing creditors in detail. Read the following to know the meaning of creditors, creditors turnover ratio, and the meaning of sundry creditors.
Creditors: An Overview
Creditors are persons, financial institutions, or other entities that allow another company or person to borrow money intended to be repaid in the future.
You can classify creditors as either personal or real. Individuals who loan money to their friends or family are personal creditors. Real creditors include banks or finance companies that have legal contracts with the borrower. Here, two types of credits are offered.
- Secured credit: This credit leverages assets against the debt, such as a house, car, or land. A mortgage loan is an example.
- Unsecured credit: Unsecured credit has a lower limit and a high-interest rate. No collaterals are needed here. A credit card is an example of unsecured credit.
Creditors gain profit by charging interest on the loans they offer their clients. For example, if a creditor lends a borrower Rs. 1,00,000 with a 5% interest rate, the lender makes money by charging interest on the loan. Here, the creditor needs to accept a degree of risk that the borrower may not repay the loan.
Multiple factors that determine the credit interest rate are:
- Creditworthiness: Before providing a loan and deciding the interest rate, lenders will examine the debtor’s creditworthiness based on their income and other financial liabilities.
- Credit Scores: Credit scores help a financial institution to know if a particular loan seeker is a low-risk debtor or high-risk debtor. For the high-risk loan applicants, the interest rate charged is considerably more, and the chances of getting loans are also low.
Example: A person “X” (borrower) decides to buy a car and approaches a bank (secured lender). The bank does a few checks on X’s credit score and ability to repay the loan before agreeing to his request. After finding that he meets all the requirements, the bank asks him to attach any of his assets worth the loan amount as collateral. Then offers him a loan of Rs. 1,00,000 with a 3% interest rate and 4 years to pay back. Even though X has to pay some additional amount over the principal amount, he will get enough time to repay the loan. If he fails to do that, the bank will seize the collateral to cover the loan amount.
Generally, there are two types of creditors in business: loan creditors and trade creditors.
a) Loan creditors are banks, financial institutions, and building societies.
b) Trade creditors are the suppliers that haven’t yet been paid for the goods or services they supplied. Here another term is essential. That is sundry creditors
Meaning of Sundry Creditors
Sundry creditors are people or suppliers from whom a business gets goods or services on a credit basis. That is, the business receives the consignment from the supplier in advance, and has to make the payment at a later date as decided by both parties. In accounting, such firms, clients, parties, companies are called sundry creditors.
Here, accounts payable (AP) is the term used to represent the money owed to vendors or suppliers for goods or services purchased on credit.
Example: Consider the example of two companies. Company A is selling hardware on a credit basis to company B.
- Let’s consider company B buys hardware from company A worth Rs 50,000 on 21 January 2021.
- Company A offers them a 3-month credit period.
- The payment is now due on 20, April 2021, and company B agrees and undertakes to make a payment of Rs. 50,000 on or before 20th April 2021.
- Here company A is the sundry creditor for company B, and to avail further and higher credit facilities, they should clear this debt on time.
Creditors and Bankruptcy
Bankruptcy is a legal process by which individuals or other entities that are unable to repay their creditors, seek relief from their debts. In fact, it is usually initiated by the debtors and imposed by a court order.
Bankruptcy filing procedures are different for different countries. In India, if a person files for bankruptcy, it will not go down well with the credit rating. It may be tough for individuals to get a new loan if they plan to start afresh. However, bankruptcy would save businesses or individuals from any financial trouble.
What is the Creditors Turnover Ratio?
The creditors turnover ratio is a measure of how frequently a company pays off its debts to its suppliers over a financial year. This resulting ratio finds the relationship between a company’s net credit purchases and the average trade payables. It is also known as the payables turnover ratio, trade payables ratio, or accounts payable turnover ratio.
Creditors Turnover Ratio Formula:
Creditors turnover ratio = (Net credit purchases / Average trade payables)
Where,
- Net Credit Purchases = (Gross Credit Purchases – Purchase Return)
- Trade Payables = (Creditors + Bills Payable)
Example:
Question: Calculate creditors turnover ratio from the following information.
Total Purchases – 10,00,000
Cash Purchases – 7,00,000
Creditors (Beginning of period) – 60,000
Creditors (End of period) – 90,000
Answer:
Creditor’s turnover ratio or Accounts payable turnover ratio = (Net credit sales / Average trade receivables)
a) Net credit purchases = Total purchases – cash purchases = 10,00,000 – 7,00,000
b) Net Credit Purchases = 3,00,000
c) Average trade payables = (Opening trade payables + closing trade payables)/2
= (60,000 + 90,000)/2
= 75,000
Creditors turnover ratio = ( 300000 / 75000 ) = 4/1 or (4:1)
A low ratio indicates that the company is in financial distress, and a high ratio indicates that creditors will be paid what they owe in a shorter period.
Conclusion
In some situations, companies lend loans from others to continue business operations, and suppliers offer a credit period to their clients to pay for the goods or equipment purchased. And, this is a common trend from large businesses to small shops. Understanding the role of a creditor and the creditor-debtor relationship is critical to running a successful business.