June 23, 2022
Explainer

Noncurrent liabilities: A how-to guide for understanding business solvency ratios

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It goes without saying that correct categorization is essential for accurate accounting. Noncurrent liabilities, which are also called long-term liabilities, are one of the many financial data points used for financial planning and analysis. That said, confusing them with short-term debt or current liabilities can lead to inaccuracies in your reporting.

In this article, we’ll define noncurrent liabilities and explain why they’re important in accounting.   

 

What are noncurrent liabilities?

Liabilities and debt are not the same thing. You’ll understand why that’s important when we get into business ratios below. Debt is any obligation associated with an outstanding balance. Liabilities include all of a company’s financial obligations, including debt. In accounting, liabilities are broken down into two categories: current and noncurrent (aka long-term).

 

Current liabilities are financial obligations that need to be paid within twelve months. Noncurrent liabilities are long-term financial obligations not due within that twelve-month period. They’re listed separately on the balance sheet so that long-term investors, owners, and shareholders can calculate the overall financial health of a company.   

 

It’s important that we define these terms before getting into why they’re important in accounting. At first glance, they seem simple enough. If the liability needs to be paid within a year, it’s current. Anything else is noncurrent. Unfortunately, that’s not always the case, which is why it’s generally best practice to have accountants on-hand to prepare your financial statements.  

 

Types of noncurrent liabilities

Long-term loans, bonds payable, and long-term lease obligations are all examples of noncurrent liabilities, but the portion of those liabilities that is due within twelve months should be listed on the balance sheet as “current portion of long-term debt” (CPLTD). Other examples of noncurrent liabilities where this is applicable include the following:

·  Mortgages

·  Equipment loans

·  Deferred tax liabilities

·  Pension benefit obligations

·  Deferred compensation

·  Deferred revenue

·  Health care liabilities

 

Short-term debt that is earmarked for refinancing can also be categorized as a noncurrent liability, but that may impact small business tax deductions. Paying current liabilities reduces a company’s net profit margin, thus minimizing tax obligations. On the other side of that, higher profits look better for investors and shareholders. We’ll get into that in more detail below.

 

Remember to separate both current and noncurrent liabilities into debt and non-debt sub-categories. The main distinguisher between the two is that debt comes with an interest payment. There’s a business profitability metric called the interest coverage ratio where that becomes important. In short, it measures whether you can afford your interest payments.   

 

Current liabilities vs. noncurrent liabilities

Current liabilities are basically the bills that need to get paid right away or within a few months. Obligations to vendors, suppliers, and payroll fall into this category. Noncurrent liabilities are the bills you can put off until later. This can increase working capital and short-term liquidity, but it can have a long-term impact on your business.

 

Let’s use the example of the short-term loan that we mentioned above. It’s due within twelve months, so it’s a current liability. Paying it off within that time frame with your liquid assets reduces the short-term liquidity of your company and lowers your profit margins. Refinancing takes it off the books for this year, increasing your profitability. Is that a good thing?

 

In this case, extending that loan through refinancing could be costly. Interest payments are current liabilities. Refinancing might lower monthly payments, but interest will still accumulate on the unpaid principal. As companies grow and it becomes necessary to take on more debt, interest payments on each of those “extended” loans increases current liabilities.

 

Leases are another area to look at here. A twelve-month lease is a current liability. A three-year lease is noncurrent. Payments during the year count towards CPLTD, but the lease itself creates a long-term obligation that affects the solvency ratio of the company. That’s why you see companies preparing for acquisition terminating their long-term leases.

 

These are just two examples of how accountants need to look at current and noncurrent liabilities. In the next section, we’ll review how noncurrent liabilities are used to measure the financial health of a business and why they’re important to accountants.    

 

Business ratios for measuring liquidity and solvency

Noncurrent liabilities are a line item on the balance sheet, so accountants need to know how to recognize them. The numbers need to be accurate because they will be used for certain business ratios that measure the liquidity and solvency of a company. Liquidity is a metric for working capital. Solvency is a company’s ability to pay its debts.

 

New business owners tend to put too much emphasis on the metrics that measure a company’s ability to pay its short-term liabilities. The business ratios for that are the “Quick Ratio” (Current Assets – Inventory ÷ Current Liabilities) and the “Current Ratio” (Current Assets ÷ Current Liabilities). The quick ratio does not include non-liquid assets.

 

The quick ratio and the current ratio don’t account for noncurrent liabilities, so they can be deceiving. Companies can have the liquidity to pay short-term debts but still fall short of meeting their long-term financial obligations. Thankfully, with an accurate balance sheet, there are solvency ratios for determining the long-term health of the business.

The fixed assets to long-term liabilities ratio

Dividing the total amount of fixed assets by the total amount of long-term financial obligations (Fixed Assets ÷ Noncurrent Liabilities) provides a number that is used by most lenders when assessing business creditworthiness. The higher the number, the healthier the company. That’s an argument for paying off debt as quickly as possible, as opposed to refinancing it.  

The interest coverage ratio 

We mentioned this ratio briefly when we spoke about types of noncurrent liabilities. The interest coverage ratio is calculated by dividing your EBITDA (earnings before interest, taxes, depreciation, and amortization) by your interest expense (EBITDA ÷ Interest Expense). If the resulting number is low, your company may be over-leveraged.   

The total debt ratio 

The total debt ratio is the simplest of the three solvency metrics and can be used for a macro view of whether the company can pay its bills. The formula is (Total Debt ÷ Total Assets). That incorporates all current and noncurrent liabilities along with liquid and illiquid assets, including unsold inventory. It’s a quick calculation, but it doesn’t tell the whole story.   

 

Why noncurrent liabilities are essential in accounting  

Using a quick ratio to see if you have enough cash to cover an expense reimbursement or two is a basic accounting exercise. Creating a balance sheet that can be used for calculating solvency ratios impacts the future of the company. Those ratios are employed by lenders, investors, and shareholders to make financial decisions that affect owners and employees.

 

Understanding noncurrent liabilities and how they can change these business ratios is an important part of an accountant’s job. Knowing when to convert current liabilities into long-term liabilities is part of that. Accurately recording the current portion of long-term debt in the proper place is another.

 

Noncurrent liabilities are important in accounting because they’re a category on the balance sheet, a document that transparently tells the world how well a business is doing. Getting this calculation right ensures that you're representing your businesses finances most accurately.

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