For many small business owners working to expand, you must first know what the three types of liabilities are, and how it affects your business.
So what is a liability?
According to the International Financial Reporting Standards (IFRS) Framework, “A liability is a present obligation of the enterprise arising from past events, the settlement of which is expected to result in an outflow from the enterprise of resources embodying economic benefits.”
In short, a liability is defined as a company’s legal financial debts or obligations that arise during the course of business operations.
How are liabilities settled?
A business can settle liabilities over time through the transfer of economic benefits such as money, goods or services. Liabilities are recorded on the right side of a company’s balance sheet.
Some examples include:
- Accounts payable
- Deferred revenues
- Accrued expenses
There are three main classifications of liabilities that your business could have. These include:
- Current Liabilities (also known as Short-Term Liabilities) are liabilities that are due and payable within one year.
- Non-current Liabilities (Long-Term Liabilities) are liabilities that are due after one year or more.
- Contingent Liabilities are liabilities that may or may not arise depending on a certain event.
Now that we have a brief overview of the three types of liabilities, let’s get into a detailed breakdown.
Understanding Current Liabilities
As mentioned before, Current Liabilities, also known as short-term liabilities, are debts or obligations that are due within one year. Management typically watches current liabilities very closely to make certain that the business possesses enough liquidity from current assets to ensure that they can actually pay off their outstanding debts or obligations.
Current liabilities could include accounts payable, interest payable, income taxes payable, bills payable, short term loans, bank account overdrafts, and accrued expenses.
Several short-term liquidity measures use Current Liabilities as a key component to analyze how a business is doing financially. Metrics management teams and investors perform financial analysis and analyze businesses using the following key ratios:
- The current ratio: Current assets divided by current liabilities
- The quick ratio: Current assets minus inventory divided by current liabilities
- The cash ratio: Cash and cash equivalents divided by current liabilities
Understanding Non-current Liabilities
Non-current Liabilities are also known as long-term liabilities. These are debts or obligations that are due in over a year’s time. Businesses take on long-term debt to acquire immediate capital—these can include funding the purchase of capital assets (i.e. an office building or computers) or investing in new capital projects. Whatever it may be, long-term liabilities are an important source of a business’ long-term financing.
Long-term liabilities are critical for determining a business’ long-term solvency. Businesses will likely face a solvency crisis if they are unable to repay their long-term liabilities as they become due.
Non-current Liabilities could include bonds payable, long-term notes payable, mortgage payable, deferred tax liabilities, and capital lease.
Understanding Contingent Liabilities
Contingent Liabilities depend on the outcome of a future event. In this case, contingent liabilities are also known as potential liabilities. For instance, if a company is facing a lawsuit of $200,000, they face a liability if the lawsuit proves successful. However, if the lawsuit is unsuccessful, the company would not face a liability.
In accounting standards, Contingent Liability is only recorded if:
- The liability is probable and;
- The amount can be reasonably estimated.
Examples of Contingent Liabilities could include lawsuits or product warranties.
Now that you have an overview of what liabilities are and the types that exist, you can be better equipped to see how your small business stands financially—both short- and long term.
Have questions? Be sure to drop us a line at firstname.lastname@example.org!