What Are Business Liabilities?
Liabilities and Accounts Payable
Liabilities are those amounts owed by a business at any one time. Liabilities are often expressed as Payables for accounting purposes. Unless you are running a complete cash business (paying and collecting only cash), you probably have liabilities.
How 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. Buying on a credit card is also borrowing unless you pay off the credit card before the end of the month. Of course, getting a business loan or a mortgage on a business property you own counts as a liability.
Your business can also have liabilities from activities like paying employees and collecting sales tax from customers. These liabilities are called trust fund taxes because you are holding them in trust and your business must count them as liabilities until they are paid.
The Different Types of Liabilities
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 owner equity are shown on the right. Liabilities are listed in a specific order on the balance sheet.
Long-term liabilities are listed first. They are the obligations of the business which are expected to continue for more than one year. These include loans payable and mortgages payable.
Short-term liabilities sometimes called current liabilities) are those obligations of the business which are expected to be paid off within a year. These 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.
- Loans and mortgages payable: These are the monthly payments on loans and mortgages.
Liabilities vs. Accounts Payable
Accounts payable (A/P) are amounts a business owes to its creditors. They are usually listed on a balance sheet as short-term even though they may continue for more than a year. An account payable might be on a credit card or to a specific vendor, like an office supply store.
The Difference Between Liabilities and Expenses
Business liability is usually money owed by a business for the purchase of an asset. 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.
An expense is an ongoing payment for something that has no tangible value, or for services. Expenses are used to generate revenue. The phones in your office, for example, are used to keep in touch with customers. Some expenses may be general or administrative, while 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.
- Because they are associated with assets, liabilities appear on the company balance sheet.
- But expenses, which are associated with revenue, appear on the company income statement (profit and loss statement).
Liabilities and Leverage
The concept of leverage for a business refers to how a business acquires new assets. If the assets are acquired by borrowing, through loans, it increases liabilities. The more loans, the more leveraged the business.
Some liability is good for a business, because leverage increases assets, 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 can serve more customers and increase 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.
Analyzing Business Liability
Businesses can measure the amount of debt (liabilities) against two other measures, to determine if the business has too much debt/liability.
Debt to Equity Ratio. The debt-to-equity ratio measures both short-term and long-term liabilities against the owner's equity account. The Balance says a ratio of more than 40-50% debt to equity means the business owner should look at reducing debt.
For example: If the equity account balance is $240,000 and debt (total of both short-term and long-term liability) is $150,000 that's a 60% ratio. This business should reduce debt.
Debt to Asset Ratio. The debt-to-asset ratio measures the percentage of total debt (both long-term and short-term) to the total business assets. You should have enough assets to sell to pay off your debt, if necessary.
A debt-to-asset ratio should be less than 50% because some assets can't be sold at their value as stated on the balance sheet. for example, accounts receivable (money owed to the business by customers) may not be collected.