Understanding Debtors: Types, Duties, and Effects

A debtor is any individual or company that is required to pay or repay money they have received. For example, when someone takes out a loan from a bank or another financial institution, they are known as a debtor.

Similarly, when the debt is in the form of securities, the same debtor is called the issuer.

Additionally, any person voluntarily filing a petition to declare bankruptcy can also be considered a debtor. For debtors, failing to make payments on time is not a crime; they may face penalties and charges. Additionally, their credit score may decrease if they fail to make payments promptly.

A debtor has the right to prioritise their repayments, except in specific situations such as bankruptcy.

In some cases, a creditor may file a lawsuit against the debtor for nonpayment, which can lead to liens and encumbrances.

Example 1: Personal Loan

X decides to renovate his home and applies for a ₹415,000 personal loan from their bank. The bank approves X's loan application and disburses the amount to X. In this situation, X becomes the debtor because he is legally obligated to repay the ₹415,000 to the bank according to the terms of the loan agreement. The bank is the creditor because it provided the funds to X.

X's loan agreement specifies that they must make monthly payments over two years. If X fails to make their payments on time, the bank may impose late fees, and X's credit score could be negatively affected.

Additionally, if X consistently misses payments, the bank might take legal action to recover the owed amount, potentially leading to a lien on X's property or other financial penalties.

Example 2: Credit Card Debt

Y uses his credit card to purchase a ₹99,600 laptop from an electronics store. The credit card company extends credit to Y, allowing him to make purchases without immediate payment. Y is the debtor in this case, as he is required to repay the ₹99,600 to the credit card company. The credit card company that issued the card and provided the credit is the creditor.

Y receives a monthly statement from the credit card company detailing his balance and the minimum payment due. If Y only makes the minimum payment, he will incur additional interest charges on the remaining balance.

Failure to make payments on time can lead to late fees and a reduction in Y's credit score. In extreme cases of nonpayment, the credit card company may pursue legal action to recover the debt, and Y could face collections or other financial repercussions.

Different types of Debtors

1. Short-Term Debtors

Short-term debtors are those who have taken out loans or credit for a period of less than one year. This type of debt is recorded as short-term receivables under current assets on the balance sheet.

2. Long-Term Debtors

Long-term debtors are those who have borrowed money or received credit for a period exceeding one year. This type of debt is recorded as long-term receivables under long-term assets on the balance sheet.

Duties of a Debtor

A responsible debtor should:

Understand Your Financial Position: Before taking on a loan, assess your current financial situation to determine how much money you have and how much you actually need.

Be Reliable: Ensure timely repayment of debts and avoid excuses for delays.

Borrow Prudently: Only seek loans when truly needed and avoid borrowing from multiple sources indiscriminately.

Make Timely Payments: Pay back debts and interest on time. Reduce unnecessary expenses to help manage your payments effectively.

Earn Trust: Timely payments help build trust with lenders, making future borrowing easier.

Benefits of Having Debtors

Debtors offer several advantages:

Increased Sales: Allowing customers to buy now and pay later can boost sales. More credit sales generally mean more debtors.

Competitive Advantage: Offering credit can enhance a business’s appeal and competitiveness.

Better Customer Relationships: Credit sales can strengthen customer relationships and enhance the firm’s reputation.

Drawbacks of Having Debtors

However, having debtors also has some downsides:

Reduced Cash Flow: A high number of debtors can lower current cash flow because significant amounts of money are tied up in unpaid receivables.

Risk of Default: More debtors increase the risk of non-payment, which can impact the firm’s financial stability.

Decreased Liquidity: High levels of outstanding debt reduce available cash, limiting the firm’s ability to invest in future opportunities.

Debtor vs Creditor

Imagine ABC Ltd. sells goods worth ₹2,000 to XYZ Ltd. on credit. This means XYZ Ltd. doesn’t pay immediately but promises to pay later.

In this situation:

XYZ Ltd. is the debtor because it owes ₹2,000 to ABC Ltd. On XYZ Ltd.'s balance sheet, this ₹2,000 is shown as an amount it needs to pay, which is a liability.

ABC Ltd. is the creditor because it is waiting to receive ₹2,000 from XYZ Ltd. On ABC Ltd.'s balance sheet, this ₹2,000 is shown as an amount it expects to receive, which is an asset.

In short, a debtor is someone who owes money, like from loans or credit cards. It's important to manage debt well to avoid extra fees and keep a good credit score.

Debtors can help businesses grow by increasing sales, but they also bring risks like less cash flow and the chance of not getting paid. Good money management means finding a balance between these benefits and risks.