Business liabilities are the debts of a firm that must be repaid eventually.
Learn how business liabilities arise and impact a business, the types of liabilities, and how to analyze them.
What Are Business Liabilities?
Business liabilities are, by definition, the amounts owed by a business at any one time. They're often expressed as "payables" for accounting purposes.
Unless you're running a complete cash business (paying and collecting only cash), your business probably has liabilities.
- Alternate name: payables
How Business Liabilities Work
When you buy anything for your business, you pay either with cash from your checking account or you borrow, and all borrowing creates a liability and a claim on your total assets by creditors that must be repaid at some point through cash or the loss of other resources.
For example, buying from suppliers on a credit card is a form of borrowing that represents a liability to your firm unless you pay off the credit card before the end of the month. Similarly, getting a bank overdraft, business loan, or mortgage on a business property you own also incurs a liability. Your business can also have liabilities from activities like paying employees and collecting sales tax from customers.
Granted, some liability is good for a business as its leverage, defined as the use of borrowing to acquire new assets, increases, and a business must have assets to get and keep customers. For example, if a restaurant gets too many customers in its space, it is limiting growth. If the restaurant gets loans to expand (using leverage), it may be able to expand and serve more customers, increasing its income. Of course, too much liability isn't good for business. If too much of the income of the business is spent on paying back loans, there may not be enough to pay other expenses. That's why it's important to keep track of liabilities and analyze them.
Liabilities are shown on your business' balance sheet, a financial statement that shows the business situation at the end of an accounting period. The assets of the business (what it owns) are shown on the left, and the liabilities and owners' equity are shown on the right, with the liabilities typically appearing above the owners' equity because it gets paid back first in the event of a firm's bankruptcy.
If the assets are acquired by borrowing, through loans, it increases liabilities. The more loans, the more leveraged the business.
Types of Business Liabilities
There are two main kinds of liabilities: those incurred in the short and long term.
Short-Term Business Liabilities
Also known as current liabilities, these are by definition obligations of the business that are expected to be paid off within a year. They're typically listed before long-term liabilities on a balance sheet, and include:
- Sales taxes payable: These amounts are collected from customers at the time of sale and held until due to be paid to the appropriate state revenue department.
- Payroll taxes payable: These amounts are collected from employees (withholding from income taxes and for employment taxes) and set aside by the employer, to be paid at the appropriate time to the IRS or state tax agencies.
- Unearned revenue: This typically refers to cash that a firm receives before it delivers goods or renders a service. It's a common liability among magazine publishers and airlines.
- Loans and mortgages payable: This represents the portion of payments on long-term loans and mortgages that is due within one year.
Long-Term Business Liabilities
Long-term or "non-current" debts and obligations are the obligations of the business that are expected to continue for more than one year. These include:
- Bonds payable: These are payments due to a bondholder on a bond, or interest-bearing note, with a maturity date that's more than one year away.
Bond interest payable, however, is typically categorized as a current liability because it's usually due within one year.
- Leases: This includes the portion of lease payments that extends past one year.
- Loans and mortgages payable: These are portions of loan or mortgage payments due after one year.
How to Analyze Business Liabilities
A business can compare the amount of debt it carries with other liquidity and solvency measures to determine if it has too much liability—namely the current ratio, debt-to-equity ratio, and debt-to-asset ratio.
This liquidity ratio helps a firm determine whether it can pay its short-term debt and meet its cash needs given its current assets and liabilities. To calculate it, divide the current assets by the current liabilities. A ratio of 2 or more is considered ideal, whereas a ratio below that may signify lower liquidity and weaker short-term paying ability.
For example, a firm with $240,000 in current assets and $120,000 in current liabilities should comfortably be able to pay off its short-term debt, given its current ratio of 2.
The debt-to-equity ratio is a solvency ratio calculated by dividing total liabilities (the sum of short-term and long-term liabilities) and dividing the result by the shareholders' equity. It can help a business owner gauge whether shareholders' equity is sufficient to cover all debt if business declines.
Generally speaking, a ratio of under 2 is desirable, but an optimal ratio is industry-specific. High-performing capital goods companies, for example, have a debt-to-equity ratio of slightly over 1; less capital-intensive industries, such as technology, more commonly have a ratio of around 0.60. Above these ratios, a business owner in the corresponding industry should look into reducing debt.
For example: If debt (short- and long-term liability combined) is $170,000 and the equity account balance is $240,000 at a technology firm, that's a ratio of 0.71. The business could try to reduce its debt further.
The debt-to-asset ratio is another solvency ratio, measuring the total debt (both long-term and short-term) relative to the total business assets. It tells you if you have enough assets to sell to pay off your debt, if necessary.
A debt-to-asset ratio should be no more than 0.3 optimally to maintain its borrowing capacity and avoid being too highly leveraged. After all, some assets can't be sold at their value as stated on the balance sheet. For example, money owed to the business by customers may not be collected.
A firm with no more than $100,000 in total debt and $360,000 in total assets, for example, has a ratio of 0.27 and thus retains its ability to borrow slightly more to finance new assets.
Business Liabilities vs. Expenses
An expense can trigger a liability if a firm postpones its payment (for example, if you take out a loan to pay for office supplies). But they're not one and the same. A business liability is usually money owed by a business to another party for the purchase of an asset with value. For example, you might buy a company car for business use, and when you finance the car, you end up with a loan—that is, a liability.
Expenses, in contrast, are costs of operation that are used to generate revenue. They're often ongoing payments you make for something that has no tangible value, or for services. The phones in your office, for example, represent an expense used to keep in touch with customers. Some expenses may be general or administrative; others might be associated more directly with sales.
Most of the payments a business makes are for expenses. For example, you may pay for a lease on office space, or utilities, or phones. If you stop paying an expense, the service goes away, or space must be vacated.
Expenses and liabilities also appear in different places on company financial statements. As mentioned earlier, liabilities appear on the company balance sheet because they are associated with assets. Expenses, which are associated with revenue, appear on the company income statement (profit and loss statement).
|Costs to acquire assets||Costs of operation|
|Incurred to obtain items of value||Paid for services or items without tangible value|
|Listed on the balance sheet||Listed on the income statement|
- Business liabilities are the debts of a business.
- A firm incurs liabilities when it borrows.
- Businesses can incur both short-term liabilities, such as sales taxes payable and payroll taxes payable, and long-term liabilities, such as loans and mortgages.
- You can use the current ratio, debt-to-equity ratio, and debt-to-asset ratio to determine whether your liabilities are manageable or need to be lowered.