A liability is a legally binding claim on the assets of a business firm or individual. Liability, in this sense, is essentially an accounting term for debt.
Virtually every business has at least some level of debt, continuously. Nearly all firms carry a non-zero accrued wages balance, for instance. This debt means they have not yet fully paid all employees, up to the minute, for all completed work. In addition, companies often carry debt for bank loans, bond issues, and other forms of notes payable and accounts payable, all at the same time. In business, such liabilities are unavoidable, normal, and expected. In business—as in personal finance—debt threatens survival only when debt level becomes unmanageable.
Businesses carry liabilities on the balance sheet under two major headings.
- First, balance sheet debt appears under Current liabilities (or Short-term liabilities). These debts may include Notes payable in 90 days, or Accrued wages—payment owed but not yet paid to employees.
- Second, balance sheet debt also appears under Long-term liabilities (or Non current liabilities) such as 5-year, 10-year, or longer term notes or bonds sold to the public.
A company's total liabilities are the sum of its short and long-term liabilities. In brief, liabilities represent the totality of a company's outstanding debt.
Liability Has Other Meanings As Well
Be aware in live discussions that "Liability" has several different meanings, all correct and all useful in business conversation. "Liability" can mean:
A legally-binding claim on the assets of a business or individual—in other words, debt (the subject of this article).
"Liable for" can mean "Responsible for".
Parents are liable for the support of their young children.
Employers can be legally liable for employee injuries on the job.
"Liability" can mean "Disadvantage."
The candidate's background has become a political liability.
Parking fees and frequent theft can make owning a car in a large city a liability.
Explaining Liability in Context
Sections below further defines and explains Liability as business debt, in the context of debt-related terms and liability metrics. Sections below focus on four themes:
- First, defining Liabilities as debts and their Balance Sheet role in creating the firm's capital structure and financial structure.
- Second, accounting treatment of short-term liabilities versus treatment of long-term liabilities.
- Third, financial metrics for debt management.
- Fourth, financial metrics for tracking debt position and leverage.
- What are liabilities in accounting?
- What is the role of liabilities on the Balance sheet?
- Everyone takes a keen interest in liabilities.
- Current liabilities (Short-term liabilities).
- Long-term liabilities / debt (Non current liabilities / debt)
- Detailed Balance sheet example with Current and Long-term liabilities.
- What are the liabilities accounts in the accounting system?
- What are the most frequently used liability-focused financial metrics?
- Three liquidity metrics involving debt.
- Three metrics for debt position and leverage.
All of the firm's Liabilities accounts and their balances are taken together as one term in the so-called Accounting Equation.
Assets = Liabilities + Owners equities
The accountin equation is also the "Balance Sheet Equation" because Assets, Liabilities, and Owner’s equities are the three top level sections of the Balance sheet. Exhibit 1, below, is a simple Balance sheet example showing how these terms provide structure for the statement.
The Balance Sheet deserves its name, moreover, because the balance between left and right sides of the equation always holds. Double-entry accounting ensures that both sides of the equation are always equal. Increases or decreases to one side of the equation always pair with equal compensating increases or decreases on the other.
In a nutshell, the equation says that the company has certain assets to work with, and that these come from two kinds of sources
- Liabilities (borrowing, or other debt)
- Owners Equity, including Retained earnings and Contributed capital from issue of stock.
The Balance sheet summarizes three categories of the firm's accounts: Assets accounts, Liability accounts, and Equities accounts. As a result the Balance sheet also describes the firm's financial structure, and capital structure (capitalization).
Short term and long-term liabilities are both of keen interest to the firm's Board of Directors, officers, senior managers, stock and bond holders, and employees. Potential investors, industry analysts and competitors also pay very close attention to the firm's liabilities.
When, for instance, a company's Current liabilities are large relative to its Current assets (assets that are relatively liquid), everyone sees that the company has a shortage of working capital. As a result, the firm may have trouble meeting near term financial obligations. If the working capital shortage is severe, the firm may even have trouble meeting payroll.
When the company's Long-term liabilities are large relative to its Balance sheet Equities, the firm is said to be highly leveraged. Leverage increases earning power in a healthy economy. In a poor economy, however, everyone knows that the highly leveraged company may have trouble servicing its debt load. The firm may have trouble paying interest on its bank loans and it may not be able to meet bond its payment obligations.
Liabilities Define Capital and Financial Structures
Red and blue borders in Exhibit 1 show how Balance sheet Liabilities accounts serve to define both capital structure and financial structure.
- Capital structure (capitalization) represents the company’s financial framework, that is, the sources of the firm's underlying value. This value consists of total securities issued such as bonds, debentures, long-term liabilities or debt, and preferred and common stock, as well as owners equities.
- Financial structure is a broader picture of this framework, which includes all of the above but also current term liabilities such as Accounts payable.
Both sets of liabilities accounts—financial structure and capital structure—in turn determine the level of financial leverage operating for the firm.
Liabilities and Equities Determine Financial Leverage
In investing and in business generally, leverage refers to the use of borrowed funds to generate earnings. In business, of course, borrowed funds represent debt, or liabilities.
Balance sheet liabilities and equities, moreover, enable the analyst to measure leverage quantitatively. Measuring leverage is essentially a matter of comparing the funds supplied by creditors (the firm's Liabilities) to the funds supplied by owners (Owner's Equities). If creditors provide more funding than owners, the firm is said to be highly leveraged.
Both creditors and owners share enterprise risks and rewards, but in proportion to their share of the funding.
Leverage in a Poor Economy
Leverage decreases earning power when business is poor. In a poor economy, debt service for borrowed funds may cost more than the borrowed funds are capable of earning. As a result, earnings may not even cover interest due for borrowed funds.
In such cases, potential lenders will probably view the highly leveraged firm as a poor credit risk. They will likely decide that the firm is in no position to take on, and service, still more debt.
Leverage in a Strong Economy
Leverage increases earning power when business is good. In a strong economy, or when the business is otherwise doing well, owners expect to earn more on borrowed funds than they pay for the cost of borrowing. This in fact is the reason owners use leverage.
Further Reading on Structures, Leverage, and Liabilities Metrics
For more on evaluating the role of liabilities in a company's financial health, see the section Liability Focused Financial Metrics, below. See the article Capital and Financial Structures for more on the impact of leverage on company profitability. And, the article Leverage illustrates leverage power and leverage risks with quantitative examples.
Acurrent 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 where they contrast with Long-term liabilities.
The Chart of Accounts for business firms normally includes Current liabilities accounts for…
- Accrued salaries due: Salary and wages owed but not yet paid to employees.
- Accounts payable: Bills the firm must pay shortly, usually within 30 days but never more than 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: Funds the firm has received from customers for goods or services, that have not yet been delivered. Unearned revenues eventually become Earned revenues—Current assets instead of Current liabilities—only when the seller delivers paid-for goods and services to the buyer.
- Taxes payable.
Current Liabilities Contribute to Liquidity, Financial Structure, and Overall Debt Position.
Not surprisingly, Balance sheet Current liabilities are central components of financial metrics that measure liquidity—the firm's ability to meet near-term financial obligations. Sections below, for instance, illustrate three such liquidity metrics: Working Capital, Current Ratio, and Quick Ratio.
Current liabilities also help define the firm's financial structure. This structure, essentially, reveals the balance between the two possible sources of funding for the firm's asset base and operations: Firstly, Equity funding and Secondly, Liability (debt) funding. As the liability portion of total funding increases, leverage increases. Note that Current liabilities do not contribute to another structure, Capital structure (see the following section).
Current liabilities also contribute to metrics that describe the firm's overall debt position. Sections below illustrate two such metrics involving Current liabilities: The Total Debt to Assets Ratio, and the Debt to Equity Ratio.
A Long-term liability (Non current liability, or Long-term debt), is a bill to pay or other debt coming due the long-term. In business, "long-term" is usually understood to mean one year or more in the future. Long-term liabilities appear under Liabilities on the Balance sheet where they contrast with Current liabilities.
The Chart of Accounts for a business firm may include Long-term liabilities accounts for…
- Long-termnotes payable.
- Mortgages payable.
- Bank notes payable.
- Bonds payable.
- Any other long-term debt.
Long-term liabilities help define two structures outlined in Exhibit 1 above: The firm's Financial structure and its Capital structure.
- Both structures reveal the balance between two sources the firm has available for funding its asset base (i.e., for capitalization). These sources are Equity funding and Liability (debt) funding. As the liability portion of total funding increases, leverage increases.
- The only difference between these two structures is that financial structure includes Current Liabilities and Long-term liabilities, while the only liabilities in capital structure are Long-term liabilities.
Long-term liabilities of course contribute to metrics that describe the firm's overall debt position. Examples illustrating three such metrics appear below as the Total Debt to Assets Ratio, Total Debt to Equity Ratio, and Long-Term Debt to Equity ratio.
The detailed Balance sheet example in Exhibit 2, below, reports account balances at one point in time—normally the end of a reporting period. Liabilities accounts appear under two sub-headings: Current Liabilities and long-Term Liabilities.
"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, for which a credit entry increases account balance (see Double-entry system for more explanation).
Transactions Impact the Income Statement and Balance Sheet
For the Income statement, such salary and wage transactions contribute to the total salary and wage expenses for the accounting period. The firm will subtract all of these salary and wage expenses (including the salary and wage expenses incurred but not yet paid to employees) 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.'
A company's liabilities are of keen interest to its Board of Directors, Senior Management, employees, stock and bondholders, potential investors—and its competitors. They may be especially interested in liability-focused financial metrics for several reasons. They may be concerned with the firm's…
- Ability to meet near-term financial obligations.
- Ability to service (i.e., pay interest on) its long-term debt and still earn acceptable margins and profits.
- Credit rating and ability to raise more funds either through borrowing (bank loans or bonds) or equity financing.
Sections below illustrate and explains five metrics that address debt-related concerns.
- Three Liquidity metrics: Working capital, current ratio, and quick ratio.
- Two metrics that describe the firm's debt position and level of leverage: Total debt to assets ratio, and Debt to equity ratio.
Liquidity metrics primarily address questions like this:
Is the firm prepared to meet its near-term financial obligations?
Firms must in the next few days or weeks pay salaries and wages due to employees. They must pay in the near term for their own purchases in the near term, including goods and services they buy "on credit." They must meet day-to-day operating expenses, such as utilities bills and internet service charges. They may have to pay floor space rental or lease charges on a monthly basis. And, they must pay service providers in the short-term, such as outside consultants, contract labor, public accountants, cleaning services, and building maintenance firms. Firms make these payments out of their own Current assets.
Liquidity metrics measure the firm's ability meet such payment needs in the near term.
All three liquidity metrics in this section require as input the same three Balance sheet figures. These figures are easily to find in both Balance sheet examples above, Exhibit 1 and Exhibit 2.
Current Assets: $9,609
Current Liabilities: $3,464
Working capital is a figure in currency units such as dollars, pounds, euro, or yen. The metric calculates simply as the difference between Current assets and Current liabilities:
Working capital = Current assets – Current liabilities
= $9,609 – $5986
How much working capital is sufficient? Company management will attempt to address that question by projecting their current liabilities for the next fiscal quarter or year and the expected cash inflows for the same period.
The current ratio metric is builds from the same input data as the working capital metric. Here, however, current ratio is the ratio resulting from dividing Current liabilities into Current assets:
Current ratio = Current assets / Current liabilities
= $9,609 / $5986
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 may be a cause for alarm.
The most severe liquidity test of the three appearing 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
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.
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 sheets in Exhibit 2 above and Exhibit 2 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
The example result 0.405 means that creditors supply 40.5% of the company's funding.
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 equity ratios measure the extent to which owner's equities can protect creditors' claims, should the business fail. Two debt to equity ratios appear here.
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 Exhibit 2 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
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 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 Exhibit 2 Balance sheet above are:
Total Long-term liabilities: $5,474,000
Total stockholder's equities: $13,137,000
Total Long-term debt to equities ratio
= Total long-term liabilities / Total stockholders equities
= $5,474,000 / $13,137,000
Rules of Thumb for Two Debt to Equities Ratios
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 as 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.