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Liability, Long Term and Short Term (Current) Liabilities Explained
Definitions, Meaning, and Balance Sheet Examples

Business Encyclopedia, ISBN 978-1-929500-10-9. Revised 2014-04-23.

In accounting, liability is just another term for debt.

In accounting, "liability" is essentially just another term for "debt," All of a company's liabilities are carried on the balance sheet, where long term debt can be compared to short term debt, and where liabilities can be compared to equities and assets.

A liability is a claim on the assets of a corporation or individual. Corporation liabilities carried on the balance sheet include current  liabilities (also known as short term liabilities), such as notes payable in 90 days, or accrued wages, owed but not yet paid to employees, and long term liabilities (or non current liabilities) such as 5-year, 10-year, or longer term notes or bonds sold to the public. The company's total liabilities are the sum of short term liabilities and long term liabilities. In brief, liabilities represent the company's outstanding debt. This item defines liability, current liability, and long term liability, in the contxbility-related terms and liability-focused financial metrics.

Liabilities accounts and their figures are one of three components of the so-called accounting equation (or balance sheet equation):

Assets = Liabilities + Owners equities

The three elements of this equation assets, liabilities, and owner’s equities are the three major sections of the balance sheet.  Through the use of double entry bookkeeping, bookkeepers and accountants ensure that the "balance" always holds (both sides of the equation are always equal). In a nutshell, the equation says that the company has certain assets to work with, and that these were acquired from two kinds of sources, (1) equity (including such things as retained earnings and contributed capital from issue of stock), and (2) liabilities (borrowing, or debt).

Liabilities are also considered major components of a company's capital structure and its financial structure.

  • Capital structure (usually synonymous with capitalization), is a measure of a company’s financial framework, covering the company’s underlying value as represented by the total securities issued, such as bonds, debentures, long term liabilities or debt, and preferred and common stock.
  • Financial structure is a broader measure of this framework, which includes all of the above but also current term liabilities such as accounts payable.

A company's liabilities are of keen interest to its Board of Directors, senior management, employees, stock and bond holders, potential investors--and its competitors.

  • If, for instance, a company's current liabilities are large relative to its current assets (assets that are relatively liquid), that is an indicator that the company has a shortage of working capital and may have trouble paying its immediate bills.
  • If the company's long term liabilities are large relative to its equities, the company is said to be highly leveraged, and may, in a difficult economy, have trouble servicing its debt load (for example, meeting bond payment obligations).

See the encyclopedia entry on capital and financial structures for more on the role of leverage through liabilities and equity funding on increasing or decreasing a company's profitability. For more on evaluating the role of liabilities in a company's financial health, see Liability Focused Financial Metrics (below).

Contents

Current liabilities (Short term liabilities)
Long term liabilities (Non current liabilities) / Long term debt 
Example balance sheet with current and long term liabilities
Liabilities accounts 
Liability focused financial metrics
     – Working capital
     – Current ratio
     – Total debt to assets ratio (Total debt ratio)
     – Quick ratio / Acid-test ratio 
     – Debt to equities ratios

Current liabilities (Short term liabilities)

A current liability, or short term liability is a bill to pay or debt coming due in the near term, usually within one year or less. Current liabilities appear under "Liabilities" on the balance sheet, and are contrasted with long term liabilities. 

Current liabilities accounts are typically recorded and reported for:

  • Accrued salaries due (Salary and wages owed but not yet paid to employees).
  • Accounts payable (bills due for payment within a year).
  • Notes payable, short term.
  • The current portion of long term debt due for payment within the year.
  • Other accrued expenses due for payment within the year.
  • Unearned revenues (money already received for goods or services not yet delivered).
  • Taxes payable.

Long term liabilities (Non current liabilities) / Long term debt 

A long-term liability, non current liability, or long-term debt, is a bill to pay, obligation, or debt coming due in the long term, usually defined as more than a year. Long-term liabilities appear under "liabilities" on the balance sheet`, and are contrasted with current liabilities. 

Long term liabilities are typically recorded and reported for:

  • Long-term notes payable.
  • Mortgages payable.
  • Bank notes payable.
  • Bonds payable.

Balance sheet example with current and long term liabilities

The balance sheet example below shows how liability accounts may be reported at the end of the accounting period. The two major liability categories are Current Liabilities and Long Term Liabilities.

Balance sheet showing liability accounts

 

Liabilities accounts

A company's bookkeepers and accountants record and report liabilities with liability accounts.  The company's complete list of accounts is called the chart of accounts, which includes three kinds of so-called balance sheet accounts and two kinds of income statement accounts. Liability accounts are found among the balance sheet accounts:

1. Asset accounts: Things of value that are owned and used by the business. 
    Example: Cash on hand
    Example: Accounts receivable
2. Liability accounts: Debts that are owed by the business.
    Example: Accounts payable
    Example: Salaries payable
3. Equity accounts: The owner's claim to business assets.
    Example: Owner capital
    Example: Retained earnings

Every one of the company's financial transactions enters the accounting system as a change in an account.  Nearly all companies, moreover, use double-entry book keeping, by which each transaction causes equal and offsetting changes in two accounts. The entry in one account called a debit and the change in another account called a credit.

For liability accounts, a debit (DR) represents a decrease in account value, while a credit (CR) represents an increase in account value. Most people are familiar with this terminology through their own personal bank checking accounts, for which the bank registers deposits to the account as credits, and withdrawals as debits. The terminology is correct from the bank's point of view, because the depositor's checking account is for the bank a liability account.

Liability account values, moreover, build through multiple transactions, as accrued liabilities (an accounting term referring to unpaid expenses also known as accrued expenses).

At the end of an accounting period, for instance:

  • A company may have incurred tax liabilities for earnings made during the period, but not yet paid.
  • The company may owe its own employees salaries and wages for work performed, but not yet paid.
  • The company may be repaying a loan and be mid way between payment due dates, meaning it already owes the lender more interest (for the part of the payment period already past), which will not be paid until the next loan payment is made.

These are all accrued liabilities. Considering the as-yet unpaid employee salaries and wages, for instance, the bookkeeper's journal entries might appear like this at the end of the year (account names and numbers refer to the example chart of accounts used throughout this encyclopedia):

Grande Corporation
Journal for Fiscal Year 20YY
Date Account Debit
Credit
31-Dec-20YY
30-Dec-20YY
 720  Salary & wage expense
 234       Payroll payable
$1,110,250  
$1,110,250

"Salary and wage expense" is an expense category account, so a debit entry increases this account balance by the debit amount. "Payroll payable" is a liability category account, so its account balance is increased by a credit entry (see Double-entry system for more explanation).

For the income statement , such salary and wage transactions contribute to the total salary and wage expenses for the accounting period. All of these salary and wage expenses (including the salary and wage expenses incurred but not yet paid to employees) will be subtracted from the period's sales revenues, in order to calculate margins and profits.

On the company's balance sheet, however, the "Payroll Payable" entry will contribute to current liabilities. It might be added in under a higher level more general listing for "Accrued liabilities" or, on a balance sheet with substantial detail, it might appear as a current liability item of its own, 'Payroll payable.'

Liability focused financial metrics

A company's liabilities are of keen interest to its Board of Directors, Senior Management, employees, stock and bond holders, potential investors--and its competitors. They may be especially interested in liability-focused financial metrics for several reasons. They may be concerned with:

  • The company's ability to pay its immediate bills.
  • The company's ability to service (i.e., pay interest on) its long term debt and still earn acceptable margins and profits.
  • The company's credit rating and ability to raise more funds either through borrowing (bank loans or bonds) or equity financing.

Balance sheet figures from the sample balance sheet for the examples below are:

Current Assets: $9,609 
Current Liabilities: $3,464
Inventories: $5,986

Examples of liability-focused financial metrics include the following

Working capital

Working capital is a figure in currency units (dor example, dollars, pounds, euro, or yen) showing the difference between current assets and current liabilities:

Working capital = Current assets – Current liabilities
                       =  $9,609 – $5986 = $3,623

How much working capital is sufficient? Company management will attempt to address that question by projecting their current liabilities for the next year and the expected cash inflows for the next year.

Current ratio

The current ratio metric is built from the same input data as the working capital metric, except that here a ratio is produced by dividing current liabilities into current assets:

Current ratio = Current assets / Current liabilities
                   = $9,609 / $5986 = 1.61

This company's current ratio may be cause for concern among analysts, because a current ratio value of 2.0 is a generally used "rule of thumb" requirement for healthy liquidity. A current ratio under 1.0 might be considered cause for alarm.

Quick ratio / Acid-test ratio

The most severe liquidity test of the three presented here is the quick ratio, or acid-test ratio. This ratio is similar to the current ratio, except that the inventories figure is subtracted from current assets before performing division. The idea is that inventories are the least liquid of the current assets components:

Quick ratio = (Current assets – Inventories ) / (Current liabilities) 
                     = ($9,609 –  $3,464)  /  $5986 = 1.03

Here, too, this company's acid-test ratio might be cause for concern. Analysts generally consider an acid-test ratio of about 1.1 as a minimum healthy level.

Total debt to assets ratio / Total debt ratio

What proportion of the company's total funding is provided by creditors? The total debt to assets ratio metric addresses this question. This metric compares two balance sheet entries, total liabilities (i.e., total debt) and total assets.

This example uses the following data from the sample balance sheet below;

Total liabilities: $8,938,000 
Total assets: $22,075,000

Total debt to assets ratio, or Debt ratio
             = Total liabilities / Total Assets   
             = $8,938,000 / $22,075,000
             = 0.405

The example result 0.405 means that  40.5% of the company's funding has been supplied by creditors.

Total debt to Assets Ratio or Debt Ratio Rule of Thumb: 

If the company needs to approach creditors for still more funding, potential lenders will very likely compare this debt ratio to the industry average. If the value is above the industry average, potential creditors may require the company to raise more equity capital before lending (thus raising the asset base, lowering the debt ratio, and providing more security for lenders if the business fails).

Debt to equities ratios

Debt to equity ratios measure the extent to which owner's equities can protect creditors' claims, should the business fail.

Total debt to equities ratio

The first of these debt to equity ratios, total debt to stockholders' equities, is the strongest of these measures, that is, it provides the most conservative view of creditor protection.  This ratio compares two balance sheet entries, Total stockholders equities and Total liabilities.

The corresponding figures for this example from the sample balance sheet below are:

Total liabilities:  $8,938,000 
Total stockholders equities: $13,137,000

Total debt to equities ratio
             = Total liabilities / Total stockholders equities
             = $8,938,000 / $13,137,000
             = 0.680

Long term debt to equities ratio

The second debt to equities ratio, long term debt to stockholders equities,  is more properly a measure of leverage, because the debt figure contains only debt to lenders, or long term debt, (as opposed to total debt, which includes debt to vendors, employees, and tax authorities as well as debt to lenders).

The corresponding figures for this example from the sample balance sheet below are:

Total long term liabilities:  $5,474,000 
Total stockholder's equities: $13,137,000

Total debt to equities ratio
             = Total long term liabilities / Total stockholders equities   
             = $5,474,000 / $13,137,000
             = 0.417

Debt to Equities Ratios Rules of Thumb:

  • Average debt to equities ratios vary widely between industries, and between companies within industries. Potential lenders will compare a company's debt to equities ratios to industry standards, but will also consider carefully the sources of the existing debt as well, along with the company's prospects for repayment. In other words, potential investors will consider the risks associated with existing debt as an important factor in addition to the debt to equity ratios themselves.
  • With the above rule of thumb in mind, potential lenders generally consider a total debt to equities ratio of 0.40 or lower as "good," and a long term debt to equities ratio of 0.30 or lower as good. As the company's debt to equities ratios rise above these values, loans become more difficult to acquire. 

By Marty Schmidt. Copyright © 2004-

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