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.