What Is a Financial Liability?
A simple financial liabilities definition will reveal that the term means something owed. Tim Donovan, Head of Corporate Communications at Fundbox, breaks down what liability is in context: “Fundamentally, accounting comes down to a simple equation. Assets = Liabilities + Equity.”
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Fully understanding the concept is to your advantage. More specifically, it enables you to assess a company’s financial health along with its capital structure. The data can help you make educated decisions based on solid data. Business owners use values to make crucial decisions. For example, it helps them decide if they need to generate cash by selling a part of their assets to pay off debts. Moreover, the same dataset serves investors as grounds for choosing for or against an investment opportunity.
Defining Financial Liability
In simple terms, financial liability is a debt or an obligation a person or company has. Otherwise said, it is a contractual obligation to pay cash or another financial asset or provide value. The obligation to deliver cash or cash equivalents may result from past transactions with other entities. To settle a liability, one must complete a transfer of economic benefits. More specifically, that may mean money, goods, or services. Liabilities include the following components:
- accounts payable;
- accrued expenses;
- deferred revenues;
Financial liabilities are first calculated at fair value plus. Instances that are not at fair value are measured via profit and loss and the net transaction costs for acquiring goods or services. A financial liability going as a derivative can be settled via either a cash exchange or a fixed amount equivalent.
What are financial liabilities used for? Good question. Together with financial assets and equity distribution, liabilities determine a company’s financial security. The data helps businesses monitor their income and expenses.
How to Analyze Financial Liabilities
At first glance, liabilities might seem like a disadvantage. However, when you view them in context, you understand that financial liabilities aim to bring benefits in the long run. Common financial liabilities include various business transactions. That may refer to exchanging services or anything that will result in an economic benefit.
The data relating to financial liabilities has a wide area of application. Investors, equity research analysts, and experts providing advice on a company’s shares and bonds all use it. Investors and traders have learned to use financial liabilities ratios to estimate the health of a business and avoid bad deals. For example, a professional can tell good debt and dangerous debt apart and only do business with healthy borrowers.
Companies keep the data about their liabilities in a balance sheet. Based on the general formula, assets are liabilities plus equity. Following the same accounting equation, deduct equity from assets to calculate liabilities. The information must follow the guidelines of the IFRS (International Financial Reporting Standards).
Types of Financial Liabilities
Depending on their due date, we can divide liabilities into two large groups: short-term or current and long-term or non-current. In short, the first type has to be paid off within one year, the other type after 12 months.
Short-Term or Current Liabilities
Current liabilities must be paid off within one year. Short-term liabilities include typical business operations that depend on the company’s liquidity. To calculate liquidity, you need to divide current liabilities from current assets. Current liabilities may refer to one of the following short-term obligations:
- Accounts payable
- Interest payable
- Accrued expenses
- Payroll expenses
- Short-term loans of one year maximum
- Income tax payables
- Bank account overdrafts
- Short-term loans
A typical example of a current liability is rent that you have to pay for your office space. Also, monthly utilities, money to pay your vendors, and similar expenses count as liabilities.
Non-Current or Long-Term Liabilities
As mentioned above, long-term liabilities are those that have to be paid after one year and more. When calculating non-current liabilities, you must deduct short-term payments like interest payable.
Long-term liabilities include:
- Bonds payable
- Notes payable
- Deferred tax liabilities
- Mortgage payable
- Capital lease
- Pension obligations
- Long-term debt
In simple terms, a 20-year mortgage counts as a non-current liability for a company. Nonetheless, the payments owed for the current year will go under current liabilities in the balance sheet.
In a nutshell, a contingent liability is one that may happen or not, following the development of an uncertain future event. A contingent liability is considered as such based on two criteria:
- It is possible to estimate the amount reasonably
- The probability of the future event is high.
Both conditions must be met to report a case of contingent liability. If your particular situation only involves one of the characteristics, you can mention it in the footnote on your balance sheet.
Legal liabilities are considered contingent liabilities. Say your company is undergoing a case of litigation. If the company has reasonable reasons to expect losses, it can express these expenses as contingent liabilities. If the outcome does not carry any financial consequences, the entity can avoid settlement.
How to Calculate Debt Ratios
Liabilities are commonly referred to as debt that must be paid off. You will thus hear about long-term debt and short-term debt in reference to short-term and long-term liabilities. To analyze financial liabilities, use the formulas below.
Debt ratio = Total debt (liabilities)/Total assets
The debt ratio compares total debt against the company’s total financial assets. The result shows a company’s leverage, i.e., how much it owes. If you get more than 1, there are more liabilities than assets.
Debt-to-equity ratio = Total debt/shareholders’ equity
Calculating this ratio reveals how much others have invested in the company vs. the shareholders. Others include lenders, creditors, and suppliers. The lower the ratio is, the more favorable the company’s equity is.
Cash flow vs total debt ratio = Operating cash flow/total debt
This ratio determines whether a company can pay its total liabilities. It is based on its finance operations over a specific timeframe. The higher its value, the more its operating cash flow is.
Capitalization ratio = Long-term debt/(Long-term debt + Shareholder’s equity)
The formula determines the leverage of a company. A low value means the business has less long-term debt and more equity.
Interest coverage ratio = earnings before interest and taxes (EBIT)/interest expense
This ratio lets you know how fast a company can pay off its debt based on its operating income for a certain period.
Debt service coverage = net operating income/total debt service.
This ratio calculates whether the entity’s net income is enough to pay off its liabilities.
Additional formulas are available. For example, the current ratio assesses an entity’s capability to repay its debt. A quick ratio will show if the company can settle its short-term debt using its current most liquid assets. Large corporations can increase their financial liability component.
Financial liabilities can be defined as future sacrifices of the benefits from current financial obligations. We distinguish between short-term and long-term financial liabilities. The data can help us calculate debt ratios, thus unveiling the company’s ability to repay its liabilities. Therefore, that is how most companies evaluate the financial health of their business. This sort of information is also beneficial for investors, business owners, and financial analysts.
What are accounts payable and accounts receivable?
Accounts payable are the funds that a company owes its creditors, such as other businesses or banks. Accounts receivable is money that your customers owe you.
How can I determine when something is a liability?
Anything that you as a business owe to service providers or lenders counts as a liability. That includes contractual obligations involving cash, assets, and service owed. Liabilities are not always legally enforceable but also stem from *equitable obligations. Reasonable probable costs depending on outcomes to happen at a future date may also count as financial liabilities.
How do I use the information about my company’s financial liabilities?
Monitoring the liabilities of your company gives you an indicator of its stability. The data is used in the entity’s financial statements and balance sheet. On top of that, liability in finance is a vital aspect of a company. It helps you assess the current portion of long-term debt. Moreover, you can estimate liability financing and avoid potentially unfavorable investments.
What are a company’s own equity instruments?
According to IAS (International Accounting Standards) 32.11 official standards, equity instruments are contracts that show your own equity after taking away all financial liabilities.
How can I correctly identify a liability on a balance sheet?
When you look at a company’s balance sheet, you will notice that it is divided into assets on the left side and liabilities plus equity on the right side. It should be visually easy to distinguish between all three components.
*An equitable obligation is a responsibility out of ethical or moral considerations. It also goes under the name of constructive obligation. An equitable obligation is the opposite of a contractually-based obligation.
What are financial liabilities examples?
Generally, anything you owe by contractual obligation is a liability. Common examples include various loans, accounts payable, accrued expenses, bills payable, etc.
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Kerry Vetter is a consumer finance expert and writer, who has been engaged in creating finance-related content for more than ten years. Her expertise is approved by obtaining a Bachelor of Science in Finance from Boston College, as well as receiving three major certificates as a professional advisor and counselor. At the moment, Kerry is an author of multiple educational articles and insights that have been created in order to increase and develop financial literacy and responsible borrowing among US citizens. Her expert relevant savings advice has helped a lot of people overcome their financial issues and find out more about principles of smart spending, the right investment decisions, and budgeting. You can read more about Kerry’s professional background here.