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What is a Liability?
A liability, in financial and economic terms, refers to a company’s obligations to anyone other than the entity itself, which it is liable to write off sometime in the future.
Liability is a primary aspect of any business organisation and is often a definitive metric to gauge a company’s financial standing and well-being. It is crucial because liabilities imply that a company has to provide economic benefits to another entity in the future. A few liabilities examples are – creditors, bank loan, etc.
In a balance sheet, liabilities are posted on the right side and assets on the left.
What are the Different Types of Liabilities?
Liabilities are primarily categorised based on the priorities they enjoy in terms of being written off the books of a company. In other words, they are segregated based on how early an organisation is liable to settle them. These types are –
- Current liabilities
It refers to those financial obligations which a company is liable to settle or pay off within 12 months. Hence, they are also called short-term liabilities. They form an essential part of a company’s workaday functions as current liabilities directly affect its working capital and impact its liquidity.
Working capital = Current assets – Current liabilities
Examples of current liabilities are – bills payables, trade payable, creditors, bank overdraft, outstanding or accrued expenses, short-term loans or debentures, etc.
Current liability also acts as a guiding component for crucial metrics that determine a company’s short-term financial strength and standing. It is used to derive ratios such as quick ratio, current ratio, and cash ratio.
- Non-current liabilities
Non-current liabilities, as the name suggests, are financial obligations which a company is not liable to pay off or settle in the short run of its business operations, i.e. 12 months. It is also referred to as long-term liabilities.
This group of liabilities is used to derive several crucial metrics which pose as formidable quantifiers of a company’s financial health. For instance, long-term debt-to-total-assets ratio aids in understanding to what extent a company is dependent on borrowings to finance its capital operations.
A low percentage implies that a company is not heavily dependent on borrowed capital and primarily functions on owner’s capital. However, it is essential to understand which percentage qualifies as healthy depends on the respective industry.
Examples of non-current liabilities are – debentures, mortgage loan, deferred tax payable, bonds, derivative liabilities, etc.
Analysts reckon a company’s potential to pay off its non-current liabilities with future earnings to determine its bankability and the risk it poses to shareholders. In other words, the non-current liabilities of a company are quintessential to approximating its long-term solvency. Hence, investors seeking to engage in long-term investments shall always glance at the long-term liabilities of an organisation before forming a decision.
- Contingent liabilities
Although it was mentioned earlier that liabilities are categorised based on their priority of settlement, this type digresses to that definition. Contingent liabilities are referred to as those obligations that might or might not arise in the future.
In the accounting context, contingent liabilities are only recorded in the books if they are at least 50% likely to occur in the future. One primary example of such is a lawsuit. A lawsuit stands a 50% chance of being successful, thus posing as a potential obligation to such an organisation.
To summarise the types, the following table enumerates the list of liabilities as per their categorisation:
|Types of Liability||List of Liabilities|
Relationship between Liabilities and Assets
It is essential to understand assets to comprehend the gravity of what are liabilities fully. Assets are what a company relies on for economic benefits, whether in the long-term or short-term. It functions as the foundation of a company’s growth and allows organisations to meet their obligations or liabilities.
Current assets are those that will bring economic benefits in the short-run and are used to meet the short-term financial necessities of a company, i.e. current liabilities. Hence, the correlation between current liabilities and assets is quintessential to a company’s liquidity.
Also, a company’s worth or book value is determined by deducting the total value of liabilities from total assets.
Owner’s equity = Total Assets – Total Liabilities
It is to be noted that, in an accounting context, owner’s equity is posted along with liabilities; however, is essentially a company’s asset.
In addition to the owner’s equity, the correlation between liabilities and assets gives rise to several ratios which investors can analyse to develop concrete opinions about a company.
Financial Ratios Involving Liabilities
The different types of ratios involving liabilities are mentioned below –
- Current ratio or Working capital ratio
Formula: Current ratio = Current assets – Current liabilities
It represents a company’s ability to settle its current financial obligations with the use of current assets at its disposal and offers an understanding of an organisation’s liquidity.
- Acid test ratio/Quick ratio
Formula: Quick ratio = (Current assets – inventories)/Current liabilities
Current assets without the inclusion of inventories are referred to as quick assets, i.e. assets that are readily available to an organisation in liquid form. Hence, this ratio provides an understanding of a company’s potential to settle its short-term or current liabilities with the use of quick assets and offers a more concentrated view of a company’s liquidity.
- Cash ratio
Formula: Cash and cash equivalents/Current liabilities
It represents a company’s potential to pay off its current financial obligations with the cash and cash equivalents it is holding at a certain point.
- Operating cash flow ratio
Formula: Operating cash flow ratio = Operating cash flow/Current liabilities
It signifies the number of times a company can pay off its current liabilities with the cash revenue it generates within a particular time frame. It allows analysts to understand the volume of cash flow of a company and the significance it holds with respect to its current liabilities.
- Debt-to-equity ratio
Formula: Debt-to-equity ratio = Total liabilities/Equity of the shareholder’s.
Debt-to-equity ratio is of capital importance to shareholders who prefer to engage in long-term investments in stocks of companies. Assessing this ratio shall provide shareholders with an understanding of whether a company holds the necessary financial potential to distribute adequate dividends.
A high ratio implies that such a company is relying excessively on borrowed funds which jacks up its fixed obligations and brings down its capability to provide dividends.
- Long-term-debt-to-total-assets ratio
Formula: LTD/TA = Long-term debts/Total assets
It represents a company’s reliability on its long-term debts such as debentures. In other words, it refers to what extent a company’s long-term debts are financing its assets. Hence, this ratio is essential in grasping the financial solvency of a company. A high ratio would imply that a company is highly dependent on its long-term debts to finance its growth operations and therefore, asserts compromised solvency.
- Total-debts-to-total-assets ratio
Formula: TD/TA ratio = (Short-term debt + long-term debt)/Total assets
It represents to what extent a company is leveraging its financial obligations to fund its growth operations. A low ratio implies that a company has a low degree of leverage, i.e. a high reliance on its capital to finance its operations, thus showing a healthy financial structure.
Ergo, individuals who are looking to invest in equity shares shall assess these ratios to compare different companies and contrast their financial health – solvency and liquidity – before forming an absolute decision.