Liability is a financial and economic term like an asset that is the major aspect of every business.
Liabilities are important for every business because liabilities signify that a company will have to provide economic benefits to another entity in the future.
Debt financing is always harmful not at all. Debt can help expand the operation of the company.
Debt financing is a cheap source of funds for many companies but whether a company makes a profit or not, the company has to pay interest at a fixed rate. Investors should be careful when analyzing the company.
What is Liability?
Liability is the monetary or legal obligations of an entity or an individual that are required to be paid off using an asset. These obligations arise due to any past event or transaction.
Liability Example:
Mr Sayan has to pay Mr Ayan as he has purchased a car from him. So, the responsibility to pay Mr Ayan is the liability of Mr Sayan.
Where are the different types of liabilities?
Liability refers to the responsibility to pay on the occurrence of a specific transaction or event. A company may also raise debt financing for business expansion or personal income.
In the 'T' format company's balance sheet, liabilities are listed on the left-hand side and assets are listed on the right-hand side.
Liabilities can be classified depending upon their nature & period. The major types of liabilities as follows:
1. Current Liabilities
Current liabilities are also called short term liabilities and these obligations have to be settled within one year.
Current liabilities indicate short term financial health and the position of a company.
It used to assist to estimate various liquidity ratios such as quick ratio, cash ratio and current ratio.
Current Liabilities Examples
Accrued Expenses: When a business accounts for expenses that will pay off in coming intervals.
Short Term Loans: It refers to the amount of money borrowed for a short term period from a bank, financial Institute for financing the working capital needs.
Bills Payable: When a business purchases products on account, which they need to repay.
Interest Payable: Any interest in loans since the last payment was made.
Tax Payable: To collect sales tax and employee discounts.
Trade Payable: Trade payables is the amount of payment to the suppliers of goods or services related to the ordinary course of a business.
Bank Overdraft: When a business accepts a bank's borrow by raising extra money in an account, takes more money than is in the account and must return it to the bank.
2. Non-Current Liabilities
Non-current assets are also called long term liabilities and these obligations have to be settled in over a year and more.
They are important to determine the long term solvency of the company. It is a significant source of a company's long term financing.
Non-current liabilities are normally loans taken by the company for new projects or purchase new fixed assets etc.
It used to help to calculate several solvency ratios such as Debt to equity ratio, Interest coverage ratio, Capital gearing ratio.
Non-Current Liabilities Examples
Mortgage Lease: A loan taken to purchase new fixed assets or expand existing business.
Deferred Tax: There is a difference between profit on the books of accounts and taxable profit because certain expenses are not recognized as business expenses under income tax provision.
Due to this, the actual tax liabilities can also vary from the estimated calculation.
Long Term Loans: The loans & obligations which are not due for one year. It may be in the form of bank loans, debentures etc.
Notes Payable: Debt or equity securities under the company.
3. Contingent Liabilities
Contingent liabilities are our potential liabilities that are an obligation that may occur in future depending upon an event, which may or may not result in cash outflows.
Generally, contingent liabilities are not included in the balance sheet. Contingent liabilities separately referred to as a note to the balance sheet.
Contingent Liabilities Example
A company is confronting a lawsuit for Rs 100,000. If the ultimate decision is in favour of the company, it will not confront any liability, but if the decision is against the company, this is a potential liability.
To shortening the types, the following table computes the list of liabilities as per their classification:
| Types of Liability | List of Liabilities |
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Relationship between Assets and Liabilities
An asset is any resource, owned by the company entity, which is capable of generating cash flows over the long term and it includes tangible assets such as land, building, machinery, and equipment as well as intangible assets such as accounts receivable, interest owed, patents, goodwill etc. It helps in the growth of a business and allows business to fulfil their obligation.
If a company deducted its total liabilities from its total assets, we get the owner's or shareholders' equity. The relationship of the three components express as follows:
Owner’s Equity = Total Assets – Total Liabilities
But, in most case, the accounting formula is represented such as:
Total Assets = Total Liabilities + Owner's Equity
These components raise different ratios which can give an overall idea about the company to the investors.
Different financial ratios involving liabilities
The different types of financial ratios involving are following -
1. Current Ratio
The current ratio is a liquidity ratio that expresses the current assets are sufficient to pay off the current liabilities within one year.
It indicates to the investors and analysts how well a company maximizes the current assets to fulfil its current debt and other payables.
Current ratio formula = (Current Assets / Current liabilities)
2. Quick Ratio
The quick ratio is an indicator of the short term liquidity position of a company and measures a company's ability to pay its short term obligations with the most liquid assets.
Its ratio establishes a relationship between the current liabilities of the company and its quick assets.
Quick ratio formula = (current Assets - inventory - prepaid Expenses) / current Liabilities
3. Cash Ratio
The cash ratio is also known as the super quick ratio that measures the cash position of the company to pay off immediate short term obligations.
Cash ratio formula = (Cash and cash equivalents / Current liabilities)
4. Debt to Equity Ratio
The debt to equity ratio is a leverage ratio that evaluates the amount of debt taken by the company per rupee of the shareholder's funds. It is reflected in long term debt and equity.
Debt to equity ratio = (Total Debt / Shareholders' Equity)
5. Debt to Asset Ratio
The debt to asset ratio is also known as the total debt to total asset ratio that shows the proportion of assets being held by a company and that is funded by debt. It is an indicator of the use of external funds in the company.
Debt to asset ratio = (Total liabilities / Total assets)
6. Interest Coverage Ratio
The interest coverage ratio is a solvency ratio that gauges the ease with which a company can pay its interest expenses on outstanding debt.
Interest coverage ratio formula = (EBIT / Interest expenses)
Those who are willing to invest in equity shares shall evaluate liquidity and solvency ratios to compare various companies and the company's financial health.
