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Understanding the Types of Business Liabilities and How to Manage Them

Most businesses have liabilities, and the only time a company might not have liabilities is if it only pays with cash and only accepts cash payments. However, since several businesses operate in digital environments, it is nearly impossible for an enterprise to thrive on cash alone.

Hence, it is common for businesses to have liabilities. These liabilities are good for a company as these are used to acquire new assets, which can help them gain and keep customers. Business liabilities are not a bad thing as long as these are managed correctly along with the enterprise’s cash flow.

Understanding the Types of Business Liabilities and How to Manage Them

What are business liabilities?

Business liabilities are obligations that a company must repay eventually. Such financial obligations include loans and legal debts that are often used to finance the business’s operations or pay to acquire new equipment or expand services.

Typically, liabilities are expressed as “payables” and are found on the right side of the balance sheet and appear above the owners’ equity because these are paid back first if the film faces bankruptcy.

Different Types of Business Liabilities

Business liabilities fall into three categories: current, non-current, and contingent liabilities. Here are their differences:

Current liabilities, also called short-term liabilities, are financial obligations that must be paid off within a year. This type of liability occurs most often compared with the other two classifications. Accordingly, since short-term liabilities need to be paid quickly within a short period, companies watch them closely to ensure proper managing of cash flow and current liquidity.

The most common types of short-term liabilities detailed in the balance sheet are accounts payable, bills payable, interest payable, income taxes payable, short-term loans, accrued expenses, and bank account overdrafts.

 

Non-current liabilities, also known as long-term liabilities, refer to financial obligations that are not due for settlement within the year. These liabilities are listed separately from short-term liabilities and are placed below the latter in the balance sheet.

Long-term liabilities could include long-term notes payable, mortgage payable, bonds payable, deferred tax liabilities, and capital lease.

 

Contingent liabilities are financial obligations that may or may not occur, depending on the outcome of a specific event. Thus, this type of liability is generally rare and unexpected, and among the common examples of contingent liabilities are pending lawsuits and product warranties.

How to Analyze and Manage Liabilities?

A business can analyze the liabilities it carries with other liquidity and solvency ratios to determine if they have too many financial obligations. They can also do this to understand their company’s current financial health and if it is capable of paying off these debts. They can then analyze how much liabilities their company could acquire to carry out business operations, limiting themselves from obtaining more debts and exceeding their financial capacity.

Small business owners can use the following key ratios to know how the business is doing financially:

Current Ratio 

The current ratio, sometimes also called the working capital ratio, is a type of financial metric that helps a company determine its ability to pay its short-term debt and maintain cash flow given its current assets and liabilities.

To calculate the ratio, divide the current assets by the current liabilities. In theory, the higher the ratio, the more capable a company can pay its obligations. A ratio of more than 2 is desirable; meanwhile, a ratio below two could indicate that the company has a weaker short-term paying ability and may signify lower liquidity.

Debt-to-Equity Ratio

The debt-to-equity (D/E) ratio is a key metric used to evaluate whether the shareholders’ equity can cover all outstanding debts if the business declines.

To calculate the D/E ratio, divide the total liabilities (the sum of short-term and long-term liabilities) by the total shareholder equity. An optimal ratio will depend on the nature of the company and the industry it belongs to. Generally, a D/E ratio below one is seen as relatively safe, while ratios of 2 or higher are considered risky.

Debt-to-Asset Ratio

Another solvency ratio is the debt-to-asset (D/A) ratio which measures the total debt (sum of short-term and long-term obligations) relative to the total assets. By using this key metric, a company can determine if it has enough assets to sell to pay off debts, if necessary.

A D/A ratio greater than one shows that the company has more liabilities than assets, detailing that a substantial portion of the assets is financed by debt. Meanwhile, a ratio below 1 points out that a more significant part of the assets is funded by equity.

Typically, a business’s D/A ratio should not be more than 0.3 to maintain its borrowing capacity and avoid acquiring a higher degree of leverage.

 

Conclusion

Understanding how business liabilities work and learning the different types of financial obligations will help small enterprises properly categorize liability accounts in their balance sheets. By doing so, businesses can maintain a record and stay up to date with their unpaid debts to vendors, employees, and customers. It also gives shareholders an idea of the company’s financial health.

Like expenses and assets, keeping track of the business’s liabilities is crucial to business owners, bookkeepers, and accountants. Through record-keeping, enterprises will know how much they owe, create a proper record of payment schedules, and see which financial obligations need to be prioritized.

To effectively manage business liabilities and ensure an accurate reflection of these financial obligations in the balance sheet or other financial statements, businesses need to employ the best practices for bookkeeping and accounting and leverage small business accounting software programs. Such modern accounting tools can simplify and improve the efficiency of accounting and record-keeping tasks.

Enterprises using cloud accounting solutions can improve their bookkeeping and accounting processes. These modern solutions can easily categorize transactions, track sales, monitor liabilities, and generate balance sheets.

Where to get easy-to-use and time-saving bookkeeping and accounting services? 

KIPPIN is a cloud-based accounting and bookkeeping service tailored to simplify the everyday tasks of businesses. We align our clients to top financial experts on our platform to take care of all your accounting and invoicing needs. We also provide software-only solutions to automate processes, making them quick, easy, and remotely accessible.

Contact us today at 1-905-581-9362 or email us at [email protected] You may also chat with us from our website and see our product and service lineup to learn more.

Sources:

  • https://www.businessnewsdaily.com/15775-business-liabilities.html
  • https://www.thebalancesmb.com/what-are-business-liabilities-398321#how-business-liabilities-work
  • https://www.indeed.com/career-advice/career-development/examples-of-liabilities
  • https://www.investopedia.com/terms/l/liability.asp