In this article, we’re going to dive into the world of liabilities. We’re also going to provide a list of liabilities to give you a better idea of what they are.
Having a good grasp of liabilities is essential. This is true for small businesses in particular. It isn’t uncommon for business owners to take out loans to put up shop and fund operations. In 2021, 31% of small businesses in the U.S. applied for traditional financing with some likely going for other lending options. Additionally, over a billion transactions across the globe are credit.
Unfortunately, it isn’t uncommon for businesses to get overwhelmed by their debts. So in this article we aim to educate you on liabilities. After all, knowing what they are is the first step to managing them well.
What Are Liabilities?
Liabilities is one of the five main types of accounts in accounting and bookkeeping. This refers to everything you owe to other people and entities. These are your debts payments, and other obligations you must render. Liabilities only occur in accrual based double-entry accounting.
How Are Liabilities Categorized on A Balance Sheet?
A balance sheet is one of the most common financial statements. It shows the assets, liabilities and equity of a company and is based on the principle of debits and credits. These show the financial position of a company at any set period. It shows what a business owes and what is owned by a business. We classify liabilities into three main categories: current, noncurrent, and contingent.
Types of Liabilities
Current (Near-Term) Liabilities
Also known as short-term liabilities, these refer to debts and obligations that must be paid within a year. These include short-term loans. (We will go through a list of liabilities and sub accounts later on in this article. )
Non-Current (Long-Term) Liabilities
Long term liabilities have a longer time period before needing to be paid. This is anywhere from over a year to several decades. Liabilities examples include pension benefits owed to retired workers and lease obligations.
Contingent Liabilities
These are liabilities that you may reasonably, but not certainly, have to pay. They are contingent, meaning they hinge on a certain outcome panning out. We consider something a contingent liability, if a) the value is assessable, and b) the outcome is likely. Examples of these include warranties and lawsuits.
Liabilities vs. Assets
Assets are another main account type and are somewhat a mirror of liabilities. While liabilities are what you need to pay others, assets are all that you own and others owe you. In double-entry accounting, liabilities have natural credit balances. Assets are naturally debits.
Liabilities vs. Expenses
Recognizing the difference between liabilities and expenses can be tricky sometimes. Both involve cash flowing out of your business. So, what’s the difference?
Well, expenses are funds dedicated to the daily operations of your business. These include your utilities, rent, other manufacturing costs, advertising and marketing, and the cost of goods sold. You can think of it in terms of due dates. Expenses have much shorter payment terms. The most common would be net 15 (within 15 days) or net 30 (within 30 days). Going past the due dates leads to them becoming liabilities.
Cash basis accounting/bookkeeping only deals in expenses. Accrual accounting includes the possibility for credit transactions and payment terms, hence the possibility for liabilities. Expenses are naturally debit accounts alongside assets. Generally, when liabilities are paid, an expense account is debited such as interest expense. While you find liabilities recorded on a balance sheet, expenses are recorded on an income statement.
Liabilities Examples
Accounts Payable
These are any purchases made on credit. Examples of this can be purchasing equipment or furniture on a payment plan or paying for raw materials on credit.
Accrued Expenses
Also commonly referred to as accrued liability, these are credit expenses that are already recognized in your books before making the full payment.
Tax Payable Accounts
These are tax payments you are required to render regularly to government entities. This includes income tax payable, sales tax payable, and payroll tax payable accounts.
Short-Term Debt
These are current liabilities that include accounts payable but also include wages due to employees, rent, and other short-term loans. Not all liabilities are debt.
Dividends Payable or Dividends Declared
Dividends are payments owed to shareholders from a business’ profits. This can be on a monthly, quarterly, or annual basis. Dividends payable, also known as accrued dividends, are dividend payments that the business has already declared but has not yet distributed to shareholders.
Unearned Revenue
Unearned or deferred revenue refers to a form of advanced payment given by consumers for a product or service not yet received. For example, say you are pre-saving a song or a video game. This is considered unearned income for the person who owes you the pre saved item.
How Do I Know If Something Is a Liability?
We can consider something a liability if:
- You purchased something on credit
- You receive any form of income that you need to pay back
- It involves interest payments
- You record a transaction as “accrued”
Essentially, if you are indebted to someone and are obliged to pay them back for a service or good they provided, it’s a liability.
What is a List of Liabilities for Individuals?
Individuals don’t have suppliers to pay or customers to serve, but they can still have liabilities. Examples of these liabilities include:
- Loans that you take out on a car or house or for other personal purchases
- Credit card payments
- Mortgage payments
- Student debt
- Loans for other personal purchases
- Any incurred interest on these loans is also part of your current liabilities
How Do I Calculate Liabilities?
Calculating liabilities involves four main steps:
- List and define each liability alongside the amount.
Ex. Payroll $30,000
- Separate them into current and noncurrent liabilities
- Calculate total short-term liabilities
- Add in long-term liabilities to get the amount of your total liabilities
What Are Liability Ratios?
The Debt Ratio
This is a ratio that compares the total debt liabilities of a company versus its total assets. The importance of this ratio is that it measures the ability of a business to pay its debts at any point in time. This means it does not matter whether the liabilities are current or noncurrent.
Debt Ratio Formula: Total Debts Liabilities / Total Assets
A value greater than 1 represents a high debt ratio. This means you have greater debt than the ability to pay for it. Even if you were to liquidate all your assets, you wouldn’t have enough. This puts you at great financial risk, and investors are likely going to think twice before financing your business.
A debt ratio equal to 1 also isn’t good, because you would have to sell all assets to pay all obligations. A debt ratio less than one is ideal. This gives investors and stakeholders confidence in your ability to meet your obligations.
The Long-Term Debt Ratio
This is very similar to the debt ratio except it only accounts for your long-term debts. You compare these against your total assets to find what percentage of your assets will be used to pay those debts.
The Long-Term Debt Ratio Formula: Total Long-Term Debts / Total Assets x100
A percentage value at or below 50% is a good ratio. This means you at least have twice as much assets as you do loans.
The Debt to Capital Ratio
This ratio measures all your debt against your capital or equity plus debt. This equity includes retained earnings, common stock, and preferred stock.
Debt to Capital Ratio Formula: Total Debt / (Total Debt + Shareholder’s Equity)
This ratio can tell you what percent of your operations are funded by liabilities versus equity.
Frequently Asked Questions
How Do Liabilities Relate to Assets and Equity?
These are all types of accounts and are the three essential parts of the accounting equation.
Assets = Liabilities + Equity
This equation shows the relationship between the three. And also shows the relationship between debits and credits. This principle is essential to remember, especially when considering the balance sheet.
These three account types are on the financial statement. They must balance out to zero when you combine the value of assets and the value of both liabilities and equity. If your liabilities and equity don’t balance against your assets on a balance sheet, you’ve done something wrong.
See, assets are naturally debit accounts and liabilities and equity are credit accounts. This means we can substitute the values in the equation to get the true to principle equation: Debits = Credits
Why Are Current Liabilities Important to Investors?
Investors look at current liabilities in particular because it’s an indicator of your financial standing. They look at your ability to meet these obligations. A lot of short-term debt is not necessarily a bad thing in and of itself.
However, if debt ratio analyses indicate more liabilities than assets, it may deter an investor. Think of it like this: if you struggle to meet short-term obligations, they will question your ability to give them a good ROI (return on investment).
How can a company manage its liabilities effectively?
- Focus on managing short-term debts. If these get out of hand, your business can sink faster.
- Focus on your budgeting and forecasting. You can’t be taking up loans if you aren’t sure if you can earn back that amount within the payment deadline.
- Maintain a good reputation with your suppliers and partners. Deferring payments too frequently reflects poorly on your business.
What Is EcomBalance?
EcomBalance is a monthly bookkeeping service specialized for eCommerce companies selling on Amazon, Shopify, Ebay, Etsy, WooCommerce, & other eCommerce channels.
We take monthly bookkeeping off your plate and deliver you your financial statements by the 15th or 20th of each month.
You’ll have your Profit and Loss Statement, Balance Sheet, and Cash Flow Statement ready for analysis each month so you and your business partners can make better business decisions.
Interested in learning more? Schedule a call with our CEO, Nathan Hirsch.
And here’s some free resources:
- Monthly Finance Meeting Agenda
- 9 Steps to Master Your Ecommerce Bookkeeping Checklist
- The Ultimate Guide on Finding an Ecommerce Virtual Bookkeeping Service
- What Is a Profit and Loss Statement?
- How to Read & Interpret a Cash Flow Statement
- How to Read a Balance Sheet & Truly Understand It
Conclusion
Liabilities are a crucial part of a lot of business. A good grasp of liabilities and how to handle them is key to keeping your business above water. Hopefully, after going through the definitions, list of liabilities, and formulas, you can now better manage your debts and obligations.
