In financial and economic terms, a liability refers to a company’s obligations to parties other than itself, which it is likely to write off at some point in the future. Liabilities play an important part in any organisation and are frequently used as a statistic to assess a company’s financial health and well-being. It’s critical because liabilities imply that a corporation may have to provide future economic advantages to another entity. Creditors, bank loans etc are examples of liabilities.
What are the Different Types of Liabilities?
They are classified mostly according to the priority they have in terms of getting written off a company’s accounts. To put it another way, they’re divided into groups based on how quickly an organisation is likely to settle them. These are the types:
1) Current liabilities
It refers to a company’s financial obligations that must be settled or paid off within a year. As a result, they’re also known as short-term liabilities. They are an important aspect of a company’s day-to-day operations since current liabilities have a direct impact on its working capital and liquidity.
Working capital = Current assets – Current liabilities
Bills payables, trade payables, creditors, bank overdrafts, ongoing or accrued expenses, short-term loans or debentures etc. are its examples .Current liability also serves as a guiding factor in determining a company’s short-term financial strength and position. It is used to derive ratios such as quick ratio, current ratio, and cash ratio.
2) Non-current liabilities
Non-current liabilities are financial obligations that a corporation is not obligated to pay off or settle in the short term of its business activities, i.e. within a year. Long-term liabilities is another name for it. These are used to calculate a number of important measures that serve as powerful indicators of a company’s financial health. For example, the long-term debt-to-total-assets ratio can help determine how reliant a corporation is on borrowings to fund its capital activities.
A low percentage indicates that a corporation is not overly reliant on borrowed funds and instead operates mostly on its own funds. However, it is critical to recognise that the percentage that qualifies as healthy varies by industry.
Debentures, mortgage loans, deferred tax payments, bonds, derivative obligations etc. are its examples. Analysts calculate a company’s ability to repay non-current liability with future earnings to measure its bankability and risk to shareholders. In other words, a company’s non-current liabilities are critical to estimating its long-term solvency. As a result, investors interested in long-term investments should constantly consider an organization’s long-term liabilities before making a decision.
3) Contingent liabilities
Although it was previously said that liabilities are classified according to their settlement priority, this kind departs from that description. Obligations that may or may not materialise in the future are referred to as contingent liabilities.
These are only recorded in the books if they are at least 50% probable to materialise in the future, according to accounting standards. A lawsuit is a good example of this. A lawsuit has a 50% chance of being successful, implying a possible responsibility to such an organisation.
Relationship between Liabilities and Assets
It is critical to comprehend assets in order to completely realise the magnitude of liability. Assets are what a corporation uses to generate revenue, whether long-term or short-term. It serves as the foundation for a company’s growth and ensures that responsibilities and liabilities are met.
Current assets, or current liabilities, are assets that will provide economic advantages in the short term and are utilised to meet a company’s short-term financial needs. As a result, the relationship between current liabilities and assets is critical to a firm’s liquidity. Deducting the total amount of liabilities from total assets determines a company’s worth or book value.
Total Assets – Total Liabilities = Owner’s Equity
It should be highlighted that while owner’s equity is recorded alongside liability in accounting, it is fundamentally a company’s asset. Aside from the owner’s equity, the relationship between liabilities and assets yields a number of ratios that investors might use to form concrete conclusions about a company.
Financial Ratios Involving Liabilities
The various forms of ratios that involve liabilities are listed below —
1) Current ratio
Formula: Current Assets – Current Liabilities = Current Ratio
The current ratio is often known as the working capital ratio. It shows a company’s ability to meet current financial obligations using current assets available to it and provides insight into the organization’s liquidity.
2) Quick ratio/acid test ratio
Formula : Current assets – inventories/Current liabilities = quick ratio
Quick assets, i.e. assets that are readily available in liquid form to an organisation without include inventory, are referred to as current assets. As a result, this ratio helps to comprehend a company’s ability to settle short-term or current liabilities using quick assets and provides a more focused perspective of a company’s liquidity.
3) Cash ratio
Formula: Cash and cash equivalents/Current liabilities
It depicts a company’s ability to pay down current financial obligations using cash and cash equivalents on hand at a given point in time.
4) Ratio of operating cash flow
The operating cash flow ratio is calculated as follows:
Operating cash flow divided by current liabilities.
It refers to the number of times a company’s existing liability that can be paid off with cash revenue over a given period of time. It enables analysts to comprehend a company’s cash flow volume and its significance in relation to its current liability.
5) Debt-to-equity ratio
Formula: Debt-to-equity ratio = Total liabilities/Equity of the shareholder’s.
The debt-to-equity ratio is critical for shareholders who wish to make long-term investments in company equities. By calculating this ratio, shareholders will be able to determine whether a company has the financial capacity to pay out enough dividends.
A high ratio indicates that a corporation is overly reliant on borrowed capital, which increases its fixed liability and reduces its ability to pay dividends.
6) Long-term-debt-to-total-assets ratio
Formula: LTD/TA = Long-term debts/Total assets
It denotes a company’s ability to repay long-term loans like debentures. To put it another way, it refers to the amount to which a company’s long-term obligations are used to fund its assets. As a result, this ratio is critical in determining a company’s financial solvency. A high ratio would imply that a company is highly dependent on its long-term debts to finance its growth operations and therefore, asserts compromised solvency.
7) Ratio of total debts to total assets
Short-term debt + long-term debt)/Total assets = TD/TA ratio
It shows how much a company is leveraging its financial responsibilities to pay its expansion plans. A low ratio indicates that a corporation has a low degree of leverage, i.e., it relies heavily on capital to fund its operations, indicating a sound financial structure.