What are Liabilities? 2024 edition with examples

What do liabilities mean in accounting?

In accounting, liabilities refer to the various debts or financial obligations a business incurs, such as bank loans, mortgages, outstanding bills, or any other amounts owed to third parties. Liabilities represent commitments to make future payments to creditors or suppliers for resources or services already received.

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How do you identify liabilities in a balance sheet?

Liabilities can be located on your company's balance sheet. The balance sheet is organised into three sections:

1. The assets section, which indicates the total value of what your company owns.
2. The equity section, which reflects the total amount invested by you and other stakeholders in your company.
3. The liabilities section, which details what your company owes.

Traditionally, balance sheets were formatted in two columns: assets on the left and liabilities along with equity on the right.

Read further: Tax Form 1120 - What It Is? Your Complete Guide.

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Example of liabilities

Most businesses categorise the liabilities on their balance sheet into two distinct groups: current liabilities and long-term liabilities.

• Current liabilities consist of debts that must be settled within the upcoming 12 months.
• Long-term liabilities are debts which are due after 12 months.

This classification serves two primary purposes:

1. It provides clarity on the liquidity of the business, indicating its ability to meet financial obligations.
2. It is required by the Generally Accepted Accounting Principles (GAAP).

Current Liabilities

These encompass all immediate financial obligations your business is expected to settle within the upcoming year. This includes outstanding bill payments, payables, taxes, unearned revenue, short-term loans, and other similar short-term obligations.

Common examples of current liabilities are:

• Accounts payable, such as amounts owed to suppliers
• Principal and interest on bank loans due within the next year
• Salaries and wages payable over the next year
• Notes payable within one year
• Income taxes
• Mortgages payable within a year
• Payroll taxes

Long-term Liabilities

Often referred to as non-current liabilities, these include obligations that are not due until after the next 12 months.

Typical long-term liabilities include:

• Principal and interest payments that are due beyond one year
• Bonds, debentures, and other long-term loans
• Deferred tax liabilities
• Lease obligations due after more than a year
• Pension obligations
• Payments on mortgages, equipment, and other capital expenditures that are not due for over a year

Let's imagine a small, hypothetical bakery business, Sweet Treats Bakery, to illustrate the balance sheet structure:

Balance Sheet for Sweet Treats Bakery as of December 31, 2023

Assets

• Cash: $15,000
• Equipment (ovens, mixers): $50,000
• Inventory (flour, sugar, etc.): $10,000
• Accounts Receivable (payments due from customers): $5,000
• Total Assets: $80,000

Liabilities

• Accounts Payable (money owed to suppliers): $7,000
• Bank Loan (for business expansion): $20,000
• Total Liabilities: $27,000

Equity

• Owner's Equity (initial investment): $40,000
• Retained Earnings (profits reinvested in the business): $13,000
• Total Equity: $53,000

Total Liabilities and Equity: $80,000

In this example, the balance sheet is divided traditionally, with assets listed on the left, showing that Sweet Treats Bakery owns $80,000 in assets. The right side is split between liabilities of $27,000, detailing what the bakery owes, and equity of $53,000, indicating the total investment by the owner and reinvested earnings. This setup helps the owner understand the business's net worth, financial commitments, and the cushion of funds provided by equity.

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What are contingent liabilities?

In addition to the standard types, some businesses might include a third category on their balance sheets called contingent liabilities. These are potential liabilities that may arise based on the outcome of certain events, such as a lawsuit or the need to honour a warranty that requires compensation to customers.

Learn more about managing bad debt expenses.

Calculating liabilities

With most modern accounting being facilitated by software, calculating your business's liabilities is generally a straightforward process. These software systems automatically generate financial statements, ensuring that, barring any bookkeeping errors, all liabilities are accurately reflected on your balance sheet. If you are calculating manually, you would sum up all liabilities recorded in your general ledger and report the total on your balance sheet.

Here are some typical calculations used in credit accounting and their significance:

Debt ratio method

One of the most critical metrics in credit accounting is the debt ratio. This ratio assesses the level of leverage within your business by comparing total liabilities to total assets, essentially indicating how much of your business is financed through debt.

The formula for debt ratio is:

‍Debt Ratio = Total Liabilities/Total Debts

‍Example:

Suppose a bookstore called Readers' Haven has total liabilities of $200,000 and total assets of $500,000. The debt ratio would be:

‍Debt Ratio = $200,000/$500,000 = 0.4%

This result means that 40% of Readers' Haven's assets are financed by debt, illustrating the extent to which the business is leveraged.

‍Note: Generally, a lower debt ratio indicates that your business is less leveraged and more able to pay off its debts, whereas a higher debt ratio suggests greater leverage and increased financial risk.

Debt ratios can differ significantly across industries, but as a rule of thumb, a debt ratio of 40% or lower is usually considered manageable. On the other hand, a debt ratio of 60% or higher might be viewed by investors and lenders as a sign that your business is overly indebted.

‍Long-term debt ratio method

This ratio, a variant of the general debt ratio, focuses specifically on long-term liabilities, excluding short-term debts from the calculation.

The formula for the long-term debt ratio is:

‍Long-Term Debt Ratio: Long-Term Liabilities/Total Assets

For instance, if a company has $10,000 in long-term liabilities and $50,000 in total assets, the long-term debt ratio would be calculated as follows:

‍Long-Term Debt Ratio: $10,000/$50,000 = 0.2%

This results in a long-term debt ratio of 20%, indicating that 20% of the company's assets are financed through long-term liabilities. A decreasing ratio over time is preferable as it indicates less reliance on long-term debt for financing. 

Conversely, an increasing ratio could signal a growing dependency on long-term debt, which might be a concern for financial stability. 

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What is the debt-to-capital ratio?

The debt-to-capital ratio is a vital measure used by potential investors and lenders to evaluate the financial health of a business.

The formula for the debt-to-capital ratio is:

‍Debt to Capital Ratio = Total Liabilities/Total(liabilities + equity)

For instance, let's calculate the ratio for Reader's Haven, which has total liabilities of $10,000 and total equity of $20,000. The debt-to-capital ratio would be calculated as follows:

‍Debt to Capital Ratio = $10,000/$10,000+$20,000 = $10,000/$30,000 = 33.3%

This ratio is crucial for comparing how leveraged your company is relative to others. A lower debt-to-capital ratio typically signifies a safer investment, as it shows less reliance on debt financing, while a higher ratio indicates a greater financial risk due to increased dependence on debt.

What is the importance of liabilities in business transactions?

Liabilities and debt ratios, such as the debt-to-capital ratio, are critical when selling or acquiring a company. Buyers generally prefer a lower ratio, which suggests more robust financial health and reduced risk.

Extend your business tax deadline by 6 months. 

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TL, DR

Let's say you have a piggy bank where you keep all the money you've saved from your allowance and birthday gifts. Imagine that your piggy bank is like a company, and the money inside it is all the things the company owns, which are called assets.

Now, suppose you borrowed some money from your friend to buy a big toy, and you promised to pay it back later. This borrowed money is like what businesses call "debt."

The debt-to-capital ratio is like looking at your piggy bank and figuring out how much of the money inside is yours and how much you owe to your friend. If you have a lot of your own money in the piggy bank and only owe a little to your friend, that means your piggy bank is in good shape! You're not depending on your friend's money too much.

But if you owe a lot more than what you have, that means you might need to be careful, because you rely a lot on the money you borrowed. Just like in business, it's good to have more of your own money and less borrowed money. That way, you can buy more toys in the future without worrying.

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Summary

Just like you wouldn't take on a mortgage you can't comfortably afford, it's wise to be cautious and thoughtful about the debt you take on as a business owner. Debt is often a necessary part of growing your business, but it's crucial to keep it within manageable levels.

Here are some tips if you find yourself needing to reduce your liabilities:

1. Prioritise your debts—focus on paying off one debt at a time, starting with the most pressing ones.
2. Negotiate better terms—talk to your creditors about lowering interest rates or renegotiating payment terms.
3. Cut unnecessary costs—reduce expenses wherever possible so you can utilise more money towards paying off debts.
4. Restructure your budget—adjust your business budget to free up additional cash for debt repayment.

Liabilities are a normal part of business operations, but by diligently monitoring your liabilities and keeping an eye on your debt ratios, you can ensure they don't restrict your business's potential to grow.

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