How to calculate liabilities for a better understanding of your businesses financial health
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The term “liability” typically has a negative connotation, but from a financial point of view, liabilities are a necessary part of growing and operating any business.
In fact, one of the most important tasks when running a small business is understanding how to record and manage the company’s assets and liabilities. Regardless of industry, healthy companies should have more assets than liabilities to maintain the liquidity necessary for current operations as well as future initiatives. Companies that have more liabilities than assets are operating at a loss.
You can find your liabilities on your company’s balance sheet, one of the four basic financial statements that indicate how a company is performing. The appropriate level of liabilities for a company will depend on many factors, including its industry, maturity, equity levels, risk appetite, and current cash flow. A company with too many liabilities relative to its assets may have trouble keeping up with vendor payments or other financial obligations.
Having insight into your company’s liabilities can help you understand the value of your company and figure out other important ratios such as debt-to-equity or working capital. Such calculations are an important part of financial planning & analysis (FP&A), which takes a holistic view of company finances to better support the company’s efforts to meet its operational and revenue goals
What are liabilities?
Liabilities are any measurable obligations of a company that will require a financial payout that the company has not yet made. These include day-to-day obligations to business partners and employees as well as debt taken on to finance the organization.
Liabilities are one component of the accounting equation used to build a balance sheet:
Every financial transaction that a company makes will impact both sides of this equation equally.
Types of liabilities
There are several types of liabilities that appear on a company’s balance sheet. Larger companies typically have more liability categories than smaller businesses.
Long-term liabilities, also called non-current liabilities, are any obligations with payments that extend for more than 12 months. This includes current-year payments on the long-term liabilities listed above. Examples of long-term liabilities include the following:
- Bonds payable
- Deferred tax liabilities
- Deferred compensation
- Pension liabilities
The long-term liabilities of a company are one factor that lenders and agencies consider when determining the creditworthiness of a business.
Short-term liabilities, also known as current liabilities, are obligations and short-term debts that a company will need to make good on within a year. Examples include:
- Accounts payable
- Dividends payable
- Taxes owed
- Lease payments
- Credit card debt
- Insurance premiums
- Unearned revenue
Analyzing this number can give you a sense of the company’s short-term financial health, which can help you determine your working capital or the money that the company can easily tap into to cover day-to-day expenses. Working capital is the difference between current assets and total current liabilities.
You can calculate the company’s working capital ratio (also called a current ratio) by dividing current assets by current liabilities. A current ratio higher than one indicates that the company may be well positioned to make good on its short-term obligations. The higher a current ratio, the more financial flexibility the company will have since it can fund initiatives or grow the business without taking on additional debt. But if a current ratio is too high it might indicate that a company is not properly deploying its capital.
Some businesses may also calculate their cash ratio, which is its total cash divided by current liabilities. This indicates how well the company could cover its obligations using only the cash it has on hand.
Some company balance sheets also have a section that includes “contingent liabilities” or those obligations that a company may or may not owe depending on external factors. Pending lawsuits are an example of a contingent liability since the company’s obligation will depend on the verdict.
Your balance sheet will also have a “total liabilities” item. This number reflects the sum of short-term and long-term liabilities (and contingent liabilities, if applicable). This is the figure that shows how much a company owes on obligations both now and in the future.
Where do I find my business's liabilities on a balance sheet?
On a typical balance sheet, you will find your company’s liabilities in the middle of the balance sheet, below the “Assets” section and above the “Owner’s Equity” section. Most balance sheets break down liabilities into individual items, listed beneath the headings “Current Liabilities” and “Long-Term Liabilities.” To the right of each item, the balance sheet will show the value of that liability, adding up to a “Total Liabilities” number.
The assets section of a balance sheet typically also breaks down into long-term and short-term sections. These include both liquid assets, or those that a company can easily convert into cash, and non liquid assets, such as real estate. Companies pay for current liabilities using current assets.
The difference between total assets and total liabilities is the value of the owner’s equity, which typically appears at the bottom of a balance sheet. Keep in mind that a balance sheet captures the financial picture of your company at one point in time. Any change in the value of assets or liabilities on the balance sheet can impact the value of equity. By comparison, a company income statement, or profit and loss statement, shows how revenues and expenses have changed over time.
How to calculate liabilities
To calculate liabilities, simply list out the amount that your company owes across all of its obligations (both current and future) and add them together. This may require gathering up bills, loan documents, and other important paperwork.
If you’re calculating liabilities without a balance sheet, the process is straightforward and if you know how to create a balance sheet, then you already have everything you need to determine your company’s liabilities as of the date of that balance sheet.
So, for example, if Company ABC owes the following:
This implies that the company will need to pay $1.7 million to remain current on its liabilities this year.
To determine your total liabilities, add together your short-term liabilities. In the example above, $20.8 million + $1.7 million = $21.5 million. So company ABC’s total liabilities are $21.5 million. If you use accounting software, it will typically calculate your liabilities for you, as long as you keep the system updated.
Using the accounting formula above, you can subtract the company’s total liabilities from the total value of the company’s assets, this will tell you the value of the company’s total equity. You can use that information to determine the company’s equity multiplier ratio, which is a financial leverage ratio that indicates to what degree shareholder equity funds assets.
What is the purpose of calculating liabilities?
A company’s liability level is one of the basic metrics that stakeholders use to understand the value and prospects for the business. It’s so important that public companies must include their balance sheet, which includes a breakdown of liabilities in the annual report that they file with the Securities and Exchange Commission (SEC).
Business leaders need a solid understanding of their current and future liabilities to properly gauge the financial health of the organization. For companies that need additional capital, their liability levels may be a key factor considered by both potential investors and lenders involved in the underwriting process if the company wants to borrow money.
If you ever decide to sell your business, potential acquirers will look at its liability levels as one factor in the company’s valuation.
Assets are those resources owned by the company that have a monetary value, including cash and investments, inventory, real estate, and accounts receivable. Liabilities, on the other hand, are those items for which the company owes money to other parties. These might include accounts payable, long-term debt, and corporate income taxes.
Companies can have many different kinds of liabilities. Typically, companies break these down into current liabilities (those due within a year) and long-term liabilities (those that require payments for more than a year). Common liabilities include accounts payable, mortgages and other debt, payroll, and rent or lease payments.
To calculate your total liabilities, you must add up both your current liability payments (those due in less than a year) and future liabilities (those due in more than 12 months). The formula is Current Liabilities + Future Liabilities = Total Liabilities