Understanding Balance Sheet Liabilities
Many successful entrepreneurs know that the majority of businesses are built on debt. While you may think of debt as being a negative thing, it is a crucial aspect of operating a small to medium business, or even a large company. In accounting terms, debts are known as liabilities and are recorded on a balance sheet. Understanding the importance of liabilities and knowing how to control the number of liabilities your enterprise has is fundamental knowledge that all businesspeople should possess. Mooncard takes you through everything you need to know about liabilities.
A definition of liabilities in accounting
In simple terms, liabilities are debts. Any sum of money that a business owes to another entity is defined as a liability. This can be debt, accounts payable, bank loans, the mortgage on a business premises or money that is scheduled to be paid to suppliers.
Almost every business will operate with some form of liability or another. Very few businesses in the modern world operate solely by paying with and accepting cash.
It is important to note that liabilities are not to be confused with expenses. Business expenses are payments for goods and services that do not have a physical value, meaning that they cannot be turned into cash.
A good example of an expense would be a company’s monthly internet and telecommunications bill. If a company wants to terminate its agreement with its internet provider and the provider charges a termination fee, then that fee would be classed as a liability.
Types of liabilities
When preparing a balance sheet, an account will separate liabilities into two distinct categories. This separation of debt is done to make it easier to calculate the liquidity of the business. This means how capable the business is of paying back its debts. It is also a requirement of the generally accepted accounting principles (GAAP) to separate liabilities in such a manner.
The two categories of liabilities that can be found on a balance sheet are:
- Current liabilities – These include any debts that must be repaid within 12 months.
- Fixed liabilities – Also known as non-current liabilities, fixed liabilities are debts that are not due to be paid for 12 months or more.
Current liabilities include any bills that have yet to be paid, taxes, short-term loans, mortgage payments, staff wages and salaries, interest on loans and so on.
Fixed liabilities are more long-term debts such as pensions for staff, interest due in more than 12 months on long-term loans, deferred tax payments, any lease payments that are due in over 12 months’ time and so on.
In some cases, accountants may list a third type of liability called contingent liabilities. These are liabilities that may become due, depending on circumstances. Examples of contingent liabilities include payments that are the result of damages being awarded in court as a result of a legal claim being made against a business or if a business has to repay customers to satisfy warranty terms.
Examples of common liabilities
Any instance where a business does not pay for services or goods outright or has borrowed funds is a liability. Some of the common liabilities incurred by businesses include:
- Credit card debts
- Mortgages on business properties
- Unpaid invoices from suppliers
- Funds accrued for paying tax, for example, VAT
- Employee wages and salaries
- Business loans
Where to locate liabilities on a balance sheet
The liabilities that a business has incurred during a fiscal year or during an accounting cycle will be listed on its balance sheet. The balance sheet is one of the three fundamental financial statements that a business should generate. The other two important statements are the income statement and the cash flow statement.
Balance sheets are typically divided into three different sections:
- An assets section which details how much value the business has
- A shareholders’ equity section which outlines how much capital investors have put into the business
- A liabilities section, which lists all money that is owed by the business
Traditionally, balance sheets have the assets on the left, the liabilities on the right and the shareholders’ equity listed underneath the liabilities section. However, since many business owners now choose to use accounting software, balance sheets often simply list assets, shareholders’ equity and liabilities using a single-column format.
If the accounts are in good financial shape, the total amount of assets should be equal to the sum of the shareholders’ equity and all liabilities. This formula is called the accounting equation and is usually displayed as:
Assets = Liabilities + Equity.
If the figures do not match, the accounts will not balance. This can be taken as a sign that either there has been a mistake in the accounting process or that the business may be in financial trouble.
Why you need to understand liabilities
Debt is most often looked at as being a negative thing. However, this is not always the case. Business owners can use their liabilities to grow and develop their businesses. While a loan is a liability, it can also provide the capital needed to purchase assets that can enrich the business, such as new equipment or vehicles.
Loans can also be used to fund marketing campaigns that improve the intangible assets of a company, such as its brand recognition or reputation. It can also be said that liabilities incurred from staff wages and salaries are also an investment in the business itself. In this way, liabilities and incurred debts are not always bad for a business.
However, taking on too many liabilities can negatively impact a business’s financial growth. Business owners and accountants need to closely monitor debt-to-asset ratios and debt-to-equity ratios. If a business does not have enough assets to cover its liabilities, it may soon find itself in serious financial difficulties.
How to calculate your liabilities
Although the majority of accounting calculations are now automated by specialised business software, it is still useful to know how to calculate liabilities and the methods that can be used to read and analyse data on the balance sheet.
The process to determine the number of liabilities is straightforward. Simply identify all current liabilities and fixed liabilities that the business has and then add them together to arrive at two sub-totals. These two amounts are then added together to provide a grand total of all liabilities owed.
Methods used to analyse liabilities further are known as credit accounting. There are three important processes used in credit accounting:
Calculating the debt ratio
The debt ratio compares the number of total liabilities to the total amount of assets to show how much debt a business is carrying. This is also known as how leveraged a business is. The lower the debt ratio, the more likely a business is to be able to pay off its debts. Higher debt ratios indicate a more leveraged business that is more of a risk for lenders or investors.
Calculating the long-term debt ratio
The long-term debt ratio follows exactly the same process; however, it does not include any current liabilities in the calculation. Calculating the long-term debt ratio shows how much debt a business will be under in the near future and can indicate that a business is too reliant on debt to enhance its growth.
Calculating the debt-to-capital ratio
The debt-to-capital ratio is often performed by investors or lenders who wish to assess the viability and liquidity of a business. The formula for the debt-to-capital ratio is:
Debt-to-capital = Total liabilities / Total liabilities + Total equity
This calculation provides a percentage that investors or lenders then use to compare one business with another in the same sector. If your company has a lower debt-to-capital ratio than a competitor, you are seen to be a safer investment. A higher debt-to-capital ratio than a competitor or similar business, however, will indicate to investors and lenders that your business has high levels of debt and may be over-leveraged, making it more of an investment risk.
Being able to manage your accounts and cash flow is crucial for any business owner. Mooncard simplifies the process of managing your business expenses. The Mooncard payment system allows you to create instant digital records and expense reports of all business purchases. When a purchase is made on behalf of a business, a digital photo of the receipt is taken which is then included in an automatically generated expense report that is sent directly to your accounting department.
You will always have a record of expenditures on hand! To arrange a free, no-obligation demonstration of the Mooncard payment system simply get in touch with the Mooncard team via our website and book a demo.