A liability obliges a company to make a payment or provide a service. It is the counterpart of an asset. Here we show you what types of liabilities there are, how they are financed and why a company should always keep an eye on them.
Liability: Meaning
Liability refers to a financial obligation of a company. This means that it has to pay a debt to another company or a private person. A classic example is a bank loan that must be repaid to the bank in monthly instalments.
What is a liability for one party is an asset for the other - and vice versa. If a company has to pay an invoice to its supplier, this invoice is a liability for the company but an asset for the supplier.
Liabilities can be divided into two categories according to their term or maturity: current and non-current, or short-term and long-term.
Liabilities are recorded on the right-hand side of the balance sheet. They are compared to assets, which represent the assets of the company.
Assets vs. liabilities
The assets of a company are made up of various assets. These include the ownership of tangible assets, financial resources, and accounts receivable and inventory. They are thus the counterpart to liabilities, which include debts, mortgages, tax payments and account payables.
Types of liability & examples
As mentioned above, liabilities are divided into two different categories: current and non-current. Current liabilities have a short term or maturity (1 year or less). Non- current liabilities represent long-term obligations that have a maturity of more than one year.
Current liabilities
Current liabilities include:
- Salary and wage payments to employees
- Accounts payables (less than 1 year)
- Loans with a term of less than one year (e.g. overdrafts) and monthly loan instalments
- Dividends that a company must pay out to its investors
- The provision of a service when an entity has received an advance payment for it
Ideally, a company pays all its current liabilities out of its current assets, i.e. out of the income it generates from its operations. If this is not the case, and it has to take out a loan to pay its current liabilities, for example, this may indicate that its business model is not profitable enough.
Non-current liabilities
The non-current liabilities include:
- Warranty services that a company promises its customers
- Expenses for events that may occur in the future, e.g. legal costs for court proceedings
- Long-term loans with a maturity of more than one year
- Payment of pensions to employees who retire at a later date
With regard to loans, it should be noted that a loan with a long term is counted as both a current and a non-current liability: The monthly loan instalments for the next 12 months are current liabilities; the remaining amount to be paid after this period is a non-current liability.
Example: A company has taken out a loan for £50,000. It has already paid off a sum of£10,000. For the next 12 months it has to pay instalments totalling £12,000. The£12,000 is therefore a current liability; the remaining £28,000 (£50,000 - £10,000 -£12,000) is a non-current liability.
Non-current liabilities are ideally financed on a long-term basis, i.e. from future revenues. Companies must therefore regularly review their current and non-current liabilities so that they can plan their financing.
Liabilities in accounting: Why is managing them so important?
A company must always be in a position to finance its liabilities. First of all, it must ensure the financing of current liabilities, i.e. generate sufficient revenues, since current liabilities should be financed from current assets.
Non-current liabilities sooner or later become current liabilities. Financing for them must be planned in advance. A company must therefore consider how it will finance its non-current liabilities in the long term.
In accounting, liabilities are compared with assets to see how the company is financed. If you subtract the assets from the liabilities, you get the equity of a company:
Equity = Assets - liabilities
This formula shows what would remain of the company's assets if all assets were liquidated and all liabilities were settled. Equity thus represents the book value of a company and is a direct indicator of how well a company is positioned financially.
