What it means
Every asset a business holds was paid for by someone. The owners paid for some through the capital they invested and the profits they left in.
Everyone else who has supplied money, goods or services and not yet been paid has, in effect, funded the rest, and the balance sheet records what the business owes them as liabilities. The accounting equation, assets equal liabilities plus equity, is simply that statement in symbols.
A liability has three characteristics in accounting terms: it is a present obligation, it arises from a past event, and settling it will require an outflow of resources. A loan drawn last year, an invoice for goods received last week and a legal claim that will probably be lost all qualify.
A contract to buy goods next month does not, until the goods arrive. A vague intention to refurbish the office does not either.
Where the amount or timing is uncertain but the obligation is probable, such as a warranty claim or a restructuring already announced, the liability is recorded as a provision, estimated as best it can be. The current and non-current split is the first thing a reader looks at.
Current liabilities must be met from current assets or new funding within a year; if they exceed current assets the business has negative working capital and a question to answer about how it will pay its bills. Non-current liabilities, mainly long-term borrowings and lease commitments, describe the business's structural funding and are compared with equity to gauge leverage.
A business with liabilities of three times its equity is financed mostly by others and has little cushion if things go wrong; one with liabilities of half its equity is conservatively funded. Liabilities are not bad in themselves.
Supplier credit, customer deposits and sensibly priced long-term debt are efficient ways to fund a business, and a company with no liabilities at all is often one that is not using its opportunities. The questions are whether the liabilities are matched by productive assets, whether the business generates enough cash to service them, and whether their maturities are spread so that no single date can bring the business down.
In practice
Real-world examples.
Example
A cafe's liabilities are its supplier invoices, staff wages accrued at month end, sales tax collected but not yet paid over, and the remaining balance on its equipment loan.
Example
An airline's largest liabilities are aircraft leases and tickets sold for flights not yet flown, the latter being a liability that is settled by carrying passengers rather than by paying cash.
Example
A manufacturer records a $2 million provision after announcing a factory closure, because the redundancy costs are now a present obligation even though no one has yet been paid.
Think of it
“Imagine your finances like a seesaw. On one side, you have what you own (assets), and on the other side, you have what you owe (liabilities). Keeping the seesaw balanced is important, so the more you owe, the more you need to own to keep things steady.
Formula
Calculation
Total Liabilities = Current Liabilities + Non-Current Liabilities
Equity = Total Assets minus Total Liabilities
Debt-to-Equity Ratio = Interest-Bearing Debt / Equity
Liabilities-to-Assets Ratio = Total Liabilities / Total Assets
Worked example. A logistics company's balance sheet:
- Accounts payable: $1,100,000
- Accrued expenses and taxes: $300,000
- Current portion of bank loans: $400,000
- Customer deposits: $200,000
- Total current liabilities: $2,000,000
- Long-term bank loans: $2,400,000
- Lease liabilities (vehicles and depot): $1,600,000
- Provision for vehicle decommissioning: $150,000
- Total non-current liabilities: $4,150,000
- Total liabilities: $6,150,000
- Total assets: $9,500,000
- Equity = $9,500,000 minus $6,150,000 = $3,350,000
Interest-bearing debt = $400,000 + $2,400,000 + $1,600,000 = $4,400,000
Debt-to-equity = $4,400,000 / $3,350,000 = 1.31
Liabilities-to-assets = $6,150,000 / $9,500,000 = 64.7%
Nearly two thirds of the company's assets are funded by other people's money, and borrowings are a third larger than the owners' stake. Whether that is dangerous depends on cash flow: if operating cash flow is $1,500,000 a year against annual debt service of $700,000, the position is manageable; if it is $600,000, the company is one bad year from trouble.Case study
Seen in the real world.
A construction company grew rapidly on the strength of large contracts and reported healthy profits, but its balance sheet told a different story that its owners never read. Liabilities had grown from $4 million to $19 million in three years: subcontractors were being paid 90 days late, the company had drawn customer advances on new projects to fund overruns on old ones, and a $6 million loan taken to buy equipment fell due in full within the year. Liabilities were 85% of assets and current liabilities exceeded current assets by $3 million.
When one large client delayed a milestone payment, the company could not pay its subcontractors, work stopped on three sites, and the resulting penalties finished it. The administrator's report noted that the income statement had shown profit in every year and that the warning had been sitting on the liabilities side of the balance sheet the whole time.
Watch out
Common mistakes.
- Judging a company on profit without reading its liabilities. Profit says nothing about whether debts can be paid when due.
- Omitting liabilities that have no invoice yet: accrued costs, provisions and lease obligations are all real.
- Treating all liabilities alike. A customer deposit settled by delivery and a loan repayment due next month carry very different risks.
Questions
People also ask.
What is the difference between a liability and an expense?
An expense is a cost consumed in the period and charged to profit. A liability is an amount owed at the balance sheet date. An unpaid expense creates a liability.
Are liabilities always bad?
No. Supplier credit, deposits and affordable long-term debt are normal and often cheaper than equity. The danger is in the amount relative to assets and cash flow, and in maturities that bunch.
What is a contingent liability?
A possible obligation that depends on an uncertain future event, such as a lawsuit that may or may not be lost. It is disclosed in the notes rather than recorded, unless it becomes probable.
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