Liabilities are debts that a company owes to another business, organization, vendor, employee, or government agency. Unless you’re running a complete cash business, your company probably has liabilities. The most common types of liabilities are accounts payable and loans payable.
Liabilities make purchasing items for your business easier, since they allow you to acquire goods and services without paying for them right away. They also help you finance your company. A small business loan, for instance, is a liability that can help you grow your business. As you pay off the loan, you can use the borrowed money to improve and expand your business and increase profits.
Too much of a good thing (in this case, debt), however, can spell trouble for a small business. A proper balance of liabilities and equity provides a strong foundation for a company. Here’s a closer look at business liabilities and how they work.
What Is a Liability?
Business liabilities are defined as the amounts owed by a business at any one time. They’re often expressed as “payables” for accounting purposes. Liabilities include small business loans, accounts payable, wages payable, interest payable, and unearned revenue.
Recorded on the right side of a balance sheet, liabilities can be contrasted with assets. While liabilities refer to things that you owe or have borrowed, assets are things that you own or are owed.
Liabilities can fluctuate daily as you add new debt and make payments. The more debts you have, the higher your liabilities are. And, the more debts you pay off, the lower your liabilities are.
Understanding Liabilities in Business
A business liability is created when a company buys an item with something other than cash or a check. Any form of borrowing creates a liability, including use of a credit card.
You also create a liability if you take out a business loan or a mortgage on a business property, use a line of credit, or get a bank overdraft. In addition, your business can have liabilities from activities like paying employees and collecting sales tax from customers.
Some liability is good for a business to use as leverage, which is the use of borrowing to increase the potential returns of a project. For example, if your coffee shop gets more customers than it can hold in its current space, using a loan to expand allows you to serve more customers and increase profits, giving you a return that can far exceed the cost of the loan.
On the other hand, too much liability isn’t good for business. If too much of a company’s income is spent on paying back loans, there may not be enough to cover other expenses. That’s why it’s important to keep track of liabilities and analyze them.
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Types of Business Liabilities
Business liabilities are grouped into two buckets: current (or short term) and non-current (or long term). Current liabilities are debts that are expected to be paid off within a year, while non-current liabilities are debts that are payable over longer than one year.
Current Liabilities
Here are some examples of current liabilities:
• Principle and interest payable: This includes any payments due towards a mortgage or small business loan that are due within the year.
• Short-term loans: These are loans that are due within 12 months, such as a business line of credit or bank overdraft.
• Accounts payable: This represents debts owed to vendors, utilities, and suppliers that have been purchased on trade credit, which may be due in 30, 60, or 90 days. Until paid, these are considered short-term liabilities.
• Taxes payable: Both state and income taxes are due within a year’s time frame, making them short-term liabilities.
• Unearned revenue: This typically refers to cash that a firm receives before it delivers goods or renders a service. The company’s liability is to deliver goods and/or services at a future date.
• Wages payable: This includes the total amount of accrued income employees have earned but not yet been paid.
Non-Current Liabilities
Here are some examples of a company’s non-current liabilities:
• Long-term notes payable: Notes payable are very similar to accounts payable except for the length of the terms for payment. When a formal loan agreement has payment terms that go beyond one year, such as the purchase of a company car or different types of business loans, it is a note payable.
• Deferred taxes: While taxes are usually considered a short-term liability, there are times where they need to be deferred for longer than a year.
• Mortgage payable: Mortgages are considered a long-term liability and are recorded as mortgage payable on the balance sheet. The monthly principal and interest payments due, however, are considered current liabilities and are recorded on the balance sheet.
Liabilities vs Assets
Assets are the things that a company owns or that are owed to the company. Assets include tangible items, such as buildings, machinery, and equipment, as well as intangible items, such as accounts receivable, interest owed, patents, or intellectual property.
When comparing a company’s assets and liabilities, the difference is the owner’s or stockholders’ equity.
The accounting equation is:
Assets – Liabilities = Owner’s Equity
Liabilities and Expenses
While expenses and liabilities may sound like pretty much the same things, they are actually different.
Liabilities are what you’re obligated to pay either in the near future or further down the road to other parties. Typically, it’s money owed for the purchase of an asset with value. For example, you might buy a car for business use. When you finance the car, you end up with a loan, or liability. Liabilities appear on the company balance sheet because they are associated with assets.
Expenses, on the other hand, are more immediate in nature. They are what your company pays on a monthly basis to fund operations and generate revenue. Expenses also include ongoing payments you make for services, such as phones or electricity. You keep track of your business expenses on your company’s income statement to determine net income. The equation to calculate net income is revenues minus expenses.
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| Liabilities | Expenses |
|---|---|
| Paid at a future date | Paid during current period |
| Recorded on the balance sheet | Recorded on the income statement |
| Offset assets | Offset revenues |
| Used to calculate owner’s/stockholders’ equity | Used to calculate net income |
Liabilities on a Balance Sheet
Liabilities are shown on your business’s balance sheet, which is a financial statement that provides a snapshot of your company’s financial health at a given moment. The balance sheet is designed to display the relationship between assets and liabilities – what you are trying to “balance” – to get a picture of your company’s net worth.
Typically, you find assets (everything your company owns) on the left-hand side of the balance sheet and liabilities, along with owner’s/shareholders’ equity (how much of the company you or your shareholders own), on the right-hand side of your balance sheet.
Pros and Cons of Business Liabilities
| Pros of Business Liabilities | Cons of Business Liabilities |
|---|---|
| Important tool for growing a business | You owe liabilities even if your business fails |
| Frees up cash for immediate needs | May come with high interest rates |
| Interest payments are often tax-deductible | Too much dependency on liabilities can hurt a company’s financials |
Analyzing Business Liabilities
Here are three key financial ratios that can help you assess whether your liabilities are manageable or need to be lowered.
Current Ratio
This ratio measures whether or not a business has enough resources to pay its bills over the next 12 months. To calculate the current ratio, you divide a firm’s current assets by its current liabilities. A good current ratio is typically considered to be anywhere between 1.5 and 3.
Debt-to-Asset Ratio
This ratio measures solvency and tells you what portion of your assets are paid for with borrowed money rather than equity. You calculate it by dividing total liabilities by total assets. A high debt-to-asset ratio indicates that a company may have trouble borrowing any more money or may have to pay a higher interest rate on a loan than it would if its ratio were lower.
Debt-to-Equity Ratio
The debt-to-equity ratio can be used to assess the extent of a firm’s reliance on debt. It is calculated by dividing a company’s total liabilities by its total owner’s or shareholders’ equity.
Generally, if a company’s debt-to-income ratio is high, it indicates that the company is at risk of financial distress (i.e., being unable to meet required debt obligations).
The Takeaway
A business incurs liabilities when it borrows. This includes short-term liabilities, such as sales taxes payable and payroll taxes payable, and long-term liabilities, like loans and mortgages.
A key part of being a successful business owner is being able to manage your liabilities. If your company has too much debt, it may be difficult to pay back should your sales slow. If it has too little debt, it may be a sign that you’re taking advantage of market opportunities.
You can use the different financial ratios, such as the current ratio and debt-to-equity ratio, to assess whether your liabilities are manageable or need to be lowered.
If you’re struggling with too much debt, you can consider a small business loan to help consolidate your debts into one loan with one monthly payment. This could allow you to pay off your debt faster, save money on interest, and shorten your loan term.
If you’re seeking financing for your business, SoFi is here to support you. On SoFi’s marketplace, you can shop and compare financing options for your business in minutes.
FAQ
What are the main types of liabilities?
Businesses sort their liabilities into two main categories: current (short-term) and non-current (long-term). Current liabilities are debts payable within one year, while long-term liabilities are debts payable over a longer period.
Is it ok for a business to have liabilities?
Yes. All businesses generally need to take on liabilities in order to operate and grow. A proper balance of liabilities and equity creates a strong foundation for a company.
Can you decrease liabilities?
Yes. As you pay off debt, your company’s liabilities decrease.
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