Creditors' equity definition

What is Creditors’ Equity?

Creditors' equity is the proportion of assets that an organization is financing with credit extended to it by creditors. It is essentially the total amount of liabilities on the balance sheet, though a case can be made that wages payable is actually employees' equity, since this is essentially credit extended to the firm by employees. A high ratio of liabilities to assets implies that a business is maintaining a low equity level, thereby using creditors to enhance its return on equity. An ancillary indicator of a high level of creditors’ equity is when a business routinely pays its suppliers on unusually long payment terms.

Example of Creditors’ Equity

Winkle Designs is a small business that has $200,000 of assets and $100,000 of liabilities. Its creditors’ equity calculation is as follows:

$100,000 Total liabilities ÷ $200,000 Total assets = 50% Creditors’ equity

In this example, the company is financing 50% of its assets through creditors. The remaining 50% is funded by the owner's equity or internal funding sources. Thus, a creditors' equity ratio of 50% indicates that creditors have a substantial claim on the company's assets, reflecting moderate leverage and financial risk.

Disadvantages of Creditors’ Equity

While the use of creditors’ equity will allow you to invest a reduced amount in a business, it also carries with it several disadvantages, which are as follows:

• Risk of credit cutbacks. If you do not pay suppliers by the pre-agreed due dates, they may cut back their credit drastically, resulting in a sudden need for funds that you may not have.

• Impact of economic contractions. When the economy contracts, suppliers are more likely to reduce the amount of credit they are offering their customers. This could result in a sudden cash crunch and possible bankruptcy, unless you can come up with alternative funding sources on short notice.