When you run your own business, liabilities will be unavoidable. Finding, recording and managing them is very important, so you need to make sure you know everything before you start your business, especially if it’s your first time.
Read our guide on everything you need to know about liabilities to find out more!
What are liabilities?
Liabilities, to put it simply, are a form of debt that you owe to someone else. For example, imagine you’ve promised to pay your friend $500 in a month’s time, but you haven’t paid the amount yet. This $500 that you owe him is therefore a liability. In a company, liabilities can be owed to many different types of parties, which can include business partners, suppliers, banks, investors, lenders and so on.
Where do I find liabilities?
Liabilities are located on a company’s balance sheet, along with assets and equity. The balance sheet is one of three financial statements that a company should have, and it is a reflection of the company’s overall financial health and net worth. For more information on balance sheets, read our article on what a healthy balance sheet looks like. Each liability will then be listed under the category.
The accounting equation, also known as the balance sheet formula, shows that your assets should be equal to your liabilities and equity:
Assets = Liabilities + Equity
When your liabilities are greater than your assets, the value of equity will be negative, meaning that your company is in debt. In other words, what your company owes is more than the value of all its assets.
Types of liabilities
There are two different types of liabilities: current liabilities and non-current (long-term) liabilities. Current liabilities are debts that must be paid back within 12 months, while non-current liabilities are debts that aren’t due for more than 12 months.
Current liabilities include things like payroll, invoices and utility bills, such as the cost to keep the electricity running in the building. Most current liabilities are payable, and you’ll find that the majority of liabilities in the balance sheet tend to be current liabilities.
On the other hand, because non-current liabilities are longer term, they’ll include things that are paid over an extended period, like mortgages and bond payables.
There’s also something called contingent liabilities that you might see on a balance sheet. These are types of liabilities that you might owe someone: for example, whether or not you have to pay a customer back if they use their warranty, or depending on the outcome of an ongoing lawsuit.
When you’re starting out your business, it’s important to make sure you know exactly when liabilities have to be paid off and then prioritise them accordingly. This is usually one of the first steps to liability management, and you can hire financial officers to do this for you. Financial officers, along with financial planning and record-keeping things like the balance sheet, also manage financial risks and write financial reports for the company.
Is there a difference between liabilities and expenses?
To put it simply, yes. Although expenses can lead to liabilities, such as when you defer payment on a purchase by, for example, taking out a loan to cover the purchase, they’re not one and the same, and you can see this on the balance sheet too, where liabilities and expenses are kept separate.
Expenses are costs that you make in order to generate revenue. For example, in a call center, the telephones represent an expense in order for the company to keep in touch with its customers. It’s often the case that expenses are payments for services, like the telephones, or things that have no tangible value, such as administrative expenses. On the other hand, liabilities are things that are owed by the business to another party in order to buy an asset with value. For example, the loan that results from financing a company car is a liability.
In addition to the accounting equation, which states that your assets should equal your liabilities and equity, there are other equations in which you might use liabilities. These types of calculations fall under credit accounting, and help you analyse the financial situation of your business further, such as whether or not your money is tied up in paying off debts.
The debt ratio
The debt ratio is an indicator of how leveraged your business is, which is to say, how burdened by debt it is. The lower the debt ratio, the less leveraged your business is, and therefore the lower the liability risk. The calculation of debt ratio is as follows:
Debt ratio = Total Liabilities / Total Assets
Generally speaking, your business is considered to be in the clear if your debt ratio is 40% or lower, although this, of course, can vary depending on the industry. It’s best to prevent your debt ratio from getting too high: for example, if your business has a debt ratio above 60%, this is generally a sign to investors and lenders that your company has too much debt, and they may not want to conduct business with you.
Long-term debt ratio
Another important calculation similar to the debt ratio is the long-term debt ratio calculation. This takes into account long-term debts, meaning that it doesn’t look at current liabilities at all.
Long-term debt ratio = Long-term Liabilities / Total Assets
Since non-current or long-term liabilities are those you pay over an extended period of time over 12 months, you want the values of your long-term debt ratio to decrease over time. If you find through your calculations that this figure is, in fact, rising, then it could potentially suggest that your business is increasingly relying on debts to grow.
Debt to capital ratio
The debt to capital ratio is a measure of the financial health and risk of your business. Often, investors and lenders will use your debt to capital ratio and compare it to another company’s in order to determine which one is safer to invest or loan to. The debt to capital ratio is calculated as follows:
Debt to capital ratio = Total Liabilities / (Total Liabilities + Total Equity)
Are liabilities always bad?
Although liabilities are essentially debts, it’s not necessarily bad to have to owe someone something. Since you obtain liabilities from purchasing valuable assets, having these liabilities is merely a part of the process to help your business operate and grow in size. Of course, if you are a small business, having too many liabilities can hurt you: you should make sure you have the assets to pay off your debts, and you can check this by looking at your balance sheet and the equations mentioned before.
Liabilities are, generally speaking, debts that you owe to someone else. These can be owed to parties like business partners, suppliers, banks, investors and lenders, and are listed in the company’s balance sheet. Although liabilities may seem like expenses, there is in fact a difference between them.
There are two different types of liabilities: current liabilities and non-current liabilities. Current liabilities are debts that must be paid back within 12 months, while non-current liabilities are debts that aren’t due for more than 12 months. There are also contingent liabilities, which may need to be paid depending on the circumstances.
Liabilities are not necessarily always bad for business, as having them is part of the process of making your business function and grow. You can check on the financial health of your business through various equations in credit accounting.