Even though no business likes to be in debt, it’s an unavoidable part of the process. What we call debt, accountants call liabilities in their accounting books. If debt is there, it’s essential that accountants can find and record it in the books.
This guide is dedicated to sharing all the information you need to understand liabilities, their types, and their importance for business accounting.
A Detailed Introduction to Liabilities
A liability is something a company or person owes to another person or company. Liabilities of all types and amounts are settled over time through the transfer of funds, goods, or services. Common types of liabilities include loans, accounts payable, mortgages, deferred revenues, bonds, warranties, and accrued expenses.
On the balance sheet, you can find liabilities on the right side, right after assets. Liabilities for one business are assets for the other. For instance, the pending invoices a restaurant has to pay amount to its liabilities. At the same time, the vendors who are ought to receive these payments, for them, these are assets.
For small or large businesses, liabilities are often used to finance operations and large-scale expansions. Some businesses completely run on liabilities because the money they owe is also their capital, which is used to finance all operations.
Generally, for large companies, dedicated financial teams handle the liability account. But for small scale businesses, business owners and managers often take this responsibility to maintain the account.
However, to manage accounting liability processes effectively, anyone handling these accounts must have a strong understanding of how liabilities work and how they can impact the organisation’s finances. It’s essential to understand how liabilities, assets, and equities affect a business’s profitability and performance.
What are the Different Types of Liabilities?
Liabilities are of two types: Current and Non-current. This classification is based on their due date or date of expiration, where current liabilities require quick action and non-current can be dealt with later.
1. Current Liabilities
These are short-term debts and obligations that must be cleared when due or within one year, either with cash or through any other payment method. Things like payrolls and monthly utility expenses are kept under this category. Examples include;
- Wages payable: It’s the total amount of salaries employees (accrued income) draw from the account every month. Each month, the total amount is added to the liabilities section. Since these liabilities can amount up, some companies have built a practice to pay their employees every two weeks.
- Interest payable: As companies use credit to purchase goods or services, the interest on these short-term credit purchases has to be paid on time.
- Dividends payable: This is the amount a company owes to its shareholders as dividends. The dividends represent payments companies pay to their shareholders for the stocks the latter have bought.
- Payments for long-term debt: All the payments due on large-amount loans with repayment periods of more than one year a current liabilities. However, the total amount pending on a long-term loan is kept under non-current liability.
- Taxes to be paid: All sorts of taxes, including income, sales, GST, etc., that have not been paid yet are also added to current liabilities.
- Accrued expenses: These are any unpaid short-term liabilities from previous accounting periods or years. Such unpaid liabilities can quickly mount up if not cleared from the books promptly.
2. Non-Current Liabilities
Non-current liabilities are expenses that are due for more than one year. The only distinction between current and non-current liabilities is the time period. Hence, any liabilities that have at least one year’s time period to be paid off, shall be included in non-current liabilities.
Non-current liabilities are among the sources of finances, including bonds, mortgages, etc. These types of liabilities are instrumental in understanding the overall liquidity and capital structure of an organisation. Accountants also ensure that non-current liabilities are paid off on time, and inability to do so means the company may face potential bankruptcy.
Heads included in non-current accounts of liabilities include;
- Bonds Payable: They represent the amount of outstanding bonds that have a maturity of over one year from the date of issue.
- Notes Payable: Notes payable are promissory notes that have a maturity date of over one year from the date of issue. These promissory notes are similar to bonds payable, and when added to the balance sheet, they indicate the total payable amount after one year.
- Deferred Tax Liabilities: This is the difference between the recognised tax amount on the income statement and the actual payable tax. The existence of this sort of liability means the company is underpaying their taxes in the current period and will have to overpay the tax.
3. Contingent Liabilities
Contingent liabilities are the expenses companies may have to pay at some point due to a lawsuit or any other unexpected expenses. This may include anything from employee compensation or paying money back to customers according to the terms of the warranty.
Calculation of Liabilities
Even though there is software for every sort of accounting calculation, it was not the case earlier. Pen, paper, and an accountant’s intelligence were the only things required to maintain accounting records.
It’s fairly simple. Accurate accounts maintenance and regular bookkeeping will ensure all business liabilities will automatically come up in the balance sheet. The manual processes included adding up every liability in the general ledger and then adding them up on the balance sheet.
What is Debt Ratio, and Why Does it Matter?
The debt ratio is a financial metric used to gauge a company’s financial performance and overall health. It’s calculated by comparing the total debt to its total assets. A debt ratio below 1 shows a company has more assets than debts, and at the same time, a debt ratio above 1 suggests that the company has more debt than assets. However, the debt ratio can also vary according to the industry.
For instance, manufacturers have a higher debt ratio than service-oriented companies. This is because manufacturers require substantial upfront investment to set up machinery, production lines, and other facilities, which is often expensive.
A low debt ratio is always preferred then a high debt ratio. Here’s why;
- Assess Financial Stability: A high debt ratio means the company heavily relies on borrowed funds to finance its daily operations. Relying on borrowed finances makes an organisation vulnerable to economic downturns and rising interest rates. But if the debt ratio is lower, it can suggest a stronger financial position and lowers the risk of default.
- Investor Confidence Analysis: In addition to checking the balance sheets, investors check the debt ratio to evaluate a company’s creditworthiness and investment potential. Companies with a low debt ratio are considered less risky and it’s even more attractive to investors.
- Provides Operator Flexibility: A high debt ratio limits a company’s financial flexibility as it will have less capital to divulge for operations and will be forced to reserve it for paying the debt. This means companies cannot invest in growth opportunities as they arise.
What’s the Importance of Liabilities in Business Accounting?
Recording liabilities on the balance sheet is important for a lot of reasons. Accurate accounting maintenance signifies how well a company runs, and regularly updating everything is also crucial to understanding its financial health and the capacity to make decisions further.
1. Ensure Accuracy in Balance Sheets and Income Statement
Liabilities are a critical component of balance sheets as they provide a snippet into the company’s financial health. At any specific point, you can judge by a company’s balance sheet how well it performs. So, adding liabilities to the sheet ensures that it reflects the business’s true financial position.
In addition to the balance sheets, liabilities also impact an income statement by covering heads like interest expenses on loans and accrued expenses. Accurate recording of liabilities information at this juncture also helps calculate the correct net income or loss.
2. Make Better Decisions After Considering All Factors
Tracking liabilities helps with debt management as you can monitor interest expenses and repayment schedules and maintain overall debt levels. Knowing all this helps make informed decisions about borrowing and repayment strategies.
Another thing for which updating liabilities is essential is effective financial planning. Knowing the liabilities of the company helps account managers anticipate future cash flows, create plans for debt repayments, and even make strategic decisions about investing in future growth opportunities.
3. Identify Potential Risks and Ensure Compliance
By keeping track of liabilities, accountants can identify potential risks associated with debt obligations. So, things like default risk or increased interest rates can increase liabilities, and knowing these can let you take proactive steps to mitigate the risks.
Moreover, some businesses must also be subject to the regulatory mandate of accurate reporting. Failure to comply with these requirements can lead to penalties and fines.
4. Accurate Liabilities Reporting Increases Investor and Creditor Confidence
Accurate and on-time reporting of liabilities accounts demonstrates a company’s resolve to ensure transparency and accountability. Investors and creditors check the accounts, and if everything is correct, it enhances the brand’s credibility and trustworthiness in the business’s financial health.
Creditors and investors often assess the company’s financial health by checking their liabilities account. Accurate reporting and record-keeping improve the chances of securing loans and attracting investments.
5. Ensure Compliance with Taxation Policies
Maintaining accounts of liabilities, including noting down interest expenses on loans, are tax deductible. Accurate record-keeping ensures businesses can claim all eligible deductions and minimise tax liabilities. Moreover, not reporting everything on time and according to the rules increases tax liabilities not to mention leads to potential penalties.
How are Liabilities Different from Assets?
Assets are opposite of liabilities, as they are the resources that generate income. Within an organisation, assets include inventory, machinery, savings, account balances, and even intellectual property.
Generally, gaining an asset means incurring a liability; for example, when buying a machine, a company takes out a loan. The loan is a liability, whereas the machine is an asset.
The work done by the machine generates income for the company, which is used to pay off the loan. So, it’s a cycle. If at any point the machine fails to generate the desired income, liabilities mount up, and if it happens regularly, it can also lead to shut down.
To Sum it Up
Liabilities, while not preferable, are an important part of every organisation. It’s a legal obligation that, today or later, has to be paid off. In a regular working organisation, liabilities mount up and reduce regularly.
More importantly, businesses can only strike off their liabilities if they report and record them properly. This is where Mocha Accounting can help, as our solution is built to help small to large-scale businesses update their books while maintaining accounts of liabilities.
Switch to Mocha Accounting Solutions to manage your liabilities and ensure the company’s effective financial health.
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