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 something that a person or company owes. Successful small businesses settle their liabilities by delivering goods, services, or money, over time. Let’s take a deeper look at the different types of liabilities that your small business could face.
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 always recorded on the right side of your company’s balance sheet.
Some examples include:
There are three main types of liabilities that your business could have, including:
- 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.
So, now that we have a brief overview of the three types of liabilities, let’s get into a more detailed breakdown.
Understanding Current Liabilities
As mentioned previously, 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, so that the business possesses enough liquidity in current assets to ensure that they can always pay off their outstanding debts or obligations.
More specifically, your current liabilities could include entries on accounts payable, interest payable, income taxes payable, bills payable, short term loans, bank account overdrafts, or and accrued expenses.
Small business owners can also use their current liabilities as a measuring stick to analyze how their business is doing financially. This is important, because further down the line, your business will be analyzed by management teams and investors using the folllowing 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 to be paid to your vendors in over a year’s time. It’s common for small businesses’ to take on long-term debt to acquire immediate capital; so whether it’s a new lease or new computer – you should always keep an eye on the maturity, or point at which your long-term liabilities, will be due.
Long-term liabilities are also critical for determining your business’ long-term solvency. No small business owner wants to be in a position where they are unable to pay their long-term liabilities, and that’s why the best accounting software for small business, like ours, exists!
Understanding Contingent Liabilities
Contingent Liabilities are debts that may or may not become payable in the future. Due to this uncertainty, they are also referred to as potential liabilities. So, what’s an example of a contingent liability? One would be in the unfortunate event that your small business becomes the subject of litigation. Should you find yourself in this situation, your business would still need to record the contingency, or possibility, of having to pay out a settlement. Thus, this is why we refer to it as ‘contingent’ – because there is uncertainty as to whether or not your small business is actually facing a liability.
In accounting standards, Contingent Liabilities are only recorded if:
- The liability is probable and;
- The amount can be reasonably estimated.
Now that you have an overview of what types of liabilities you might face as a small business owner, we hope that you’re better equipped to see how your small business stands financially – in both the short and long-term. And don’t forget – using small business accounting software like TrulySmall will ensure that you always stay on top of liabilities, so that they don’t get on top of your growth.
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