Liabilities are a fact of life for businesses. They're essentially debts owed by a business that need to be settled via the payment of cash or assets.
Liabilities are often coupled with assets, and appear on a company's balance sheet opposite assets. On a balance sheet, liabilities are listed as credits, while assets are listed as debits. A balance sheet is a statement/ document that presents a company's financial picture, showing assets, liabilities and cash on hand, among other data.
The balance statement reveals what assets a company holds hold minus money owed. That said, a balance sheet's assets and liabilities aren't just about what money a company has in hand and what it owes out, it also represents the credit risk the company is to potential lenders and creditors.
For example, if you're looking to borrow $250,000 for some new business initiatives, a balance sheet is a good snapshot of your company's financial health, giving creditors a good look at your firm's credit risk. In general, the more liabilities you have, the larger the credit risk the company is to a lender.
Debt Plays a Big Role in Company Liability
To understand liabilities, you need to understand debt, and how companies handle the amount of money they owe.
In commerce, companies often view debt as something basic and understandable, like credit card debt or loan debt. But debt comes in other forms, too.
For instance, debt can be taxes a business has to pay, or interest on a loan that has accumulated, but hasn't paid yet. Since these debts haven't been invoiced to the company yet, they really, after the fact, aren't debts - they are liabilities in the eyes of corporate finance officers.
Similarly, if you buy a dozen computers or a new warehouse, those are essential assets to the company, as they contribute to the bottom line. Yet since the company hasn't yet paid for the warehouse or for the computers, until they do, those items aren't really debt - they're liabilities.
Different Forms of Liabilities
To figure out a company's ability to pay current liabilities, you need to calculate the "current ratio" formula, which is a company's current assets divided by its liabilities. The higher the ratio, the better the liability scenario for that company.
Typically, liabilities are owed to a variety of interests, including suppliers, business partners, banks or credit unions, lenders, former employees (in the form of pension payments), investors and occasionally to business customers.
Those liabilities can be recorded as "current liabilities," which are debts that need to be paid within one year, or "long-term liabilities," which can be paid in one year or later.
- Short-term liabilities. Short-term liabilities include payable items like payroll and to keep the lights on in the building. All things being equal, most of a company's liabilities will come in the form of short-term liabilities.
- Long-term liabilities. Long-term liabilities are all other liabilities that aren't short-term liabilities. Things like mortgages and bond payables are deemed long-term liabilities, as they can be paid off over the long haul.
Company decision-makers would do well to figure out which liabilities need to be paid right now and which can be paid off over the course of a few years. Prioritizing liabilities is job one for company financial officers, and it's also the first step in the liability management process.
Examples of Current (Short-Term) Liabilities
- Worker's paychecks
- Accounts payable
- Office equipment, furniture and supplies
- Lights, heat/ac and other utilities
- Long-term liabilities
Examples of Long-Term Liabilities
- Accrued expenses
- Loans or credit paid out one year or longer
- Mortgages or rent
- Deferred taxes
When you balance your assets against your liabilities, and see that your assets outweigh your liabilities, you have what accountant calls "positive equity." When you have positive equity, you have enough cash to handle your bills and have some money left in the company till.
If your liabilities outweigh your assets, then you have "negative equity", meaning you don't have enough cash on hand to handle your bills. In that case, you simply owe more money than you have on hand.
Liabilities do have an upside or two for a company.
For starters, they can simplify your purchasing power, primarily because liabilities buy you time to pay your bills - you're simply billed by the vendor, an invoice is created, and you pay the bill on or before a future due date. The time between receiving the invoice and paying it means that the cash you owe is a liability.
Liability can also help you grow your business.
For instance, the money you borrow from a bank or credit union does have to be paid back, and it does represent a liability. But the money borrowed can be put to good use, buying equipment, hiring employees, and pushing new products and services out to the marketplace.
Those are the moves you need to grow and sustain your business in a competitive market.
Liabilities vs. Expenses
Sometimes, companies - especially smaller ones just starting out - confuse liabilities and expenses.
That's understandable, as both share commonalities - they do represent money that, sooner or later, has to be paid out.
But there is a big difference between liabilities and expenses. By definition, an expense represents a debt that triggers regular (i.e. monthly or quarterly) payments, for services and not for tangible products like equipment or buildings.
Liability isn't an expense - it's cash owed to an entity for physical assets. When you take out a loan for a new computer server, the loan taken out represents a liability.
Companies routinely pay for services that trigger expenses, but those payments don't appear on a company's balance sheet, as do liabilities. Instead, they appear on a company's profit and loss statement, along with revenues.
Companies may also calculate their liability burden much like they would measure debt. A business can do so by measuring liabilities against two other barometers, and find out just how much liability the company is up against.
- Debt-to-equity ratio. Debt-to-equity ratio calculates the total amount of liabilities, short- and long-term, against the company's equity account. By and large, anything approaching a ratio of 50% of debt to equity should be a red flag for business owners, who are facing uncomfortably high levels of debt.
- Debt-to-asset ratio. This ratio calculates the percentage of total liabilities in relation to a company's total assets. By and large, a company should have a high level of assets, in case they need those assets to pay debts and liabilities.
Get to Know Liabilities
Managing a business is difficult enough without knowing what financial liabilities you have, how to distinguish them as either short-term or long-term, and set about paying them off.
A good tutorial on liabilities can make a big difference to a company's bottom line, and help the business keep growing over the long haul.
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