What is liability?

Liability refers to the obligations of a company to a supplier, lender, bank, or other providers of goods, services, or loans. It requires an entity to give up a part of its economic benefit for settling past events or transactions. Liabilities can be listed under accounts payable of a balance sheet.

Liabilities - Definition, Importance, Types & Impact on Business

Liability is a primary aspect of any business firm and is often used as a metric for gauging the financial standing as well as the well-being of a company. It is crucial as it indicates that the company has to share its economic benefits with others in the future. 

The liabilities section can be found in the balance sheet right opposite to the assets section. Liabilities in the balance sheet are entered as credits whereas the assets are entered as debits. 

Key Highlights:

  • Liabilities form a crucial aspect for any business entity and help in gauging the financial health of an organization.
  • Liability refers to a present obligation for any enterprise arising from past events and its settlement is expected to result in the outflow from its economic benefits   
  • Too much liability can harm the financial health of a business. Hence, the owners need to keep a tab on their debt-to-asset and debt-to-equity ratios.

Types of liabilities:

 Liabilities are categorized primarily based on the priorities which they enjoy in terms of being written off.  They are primarily segregated depending on how early a business is liable to settle them.  

  • Current Liabilities 

It refers to the financial obligations which a company is liable to pay off or settle within 12 months. Hence, these are also referred to as short-term liabilities. These form a crucial part of the workday functions of a company and have a direct impact on its liquidity and working capital.   

Working capital = Current assets - Current liabilities

Examples of current liabilities include creditors, trade payable, bank overdraft, accrued expenses, debentures, short-term loans, bills payable, etc. 

Current liability also serves as a guiding component for crucial metrics that determine the short term financial strength of a company. It is also utilized for deriving ratios such as cash ratio, current ratio, and quick ratio.

  • Non-current liabilities 

Non-current liabilities refer to financial obligations which a company cannot settle or pay off in the short run of its operations. Hence, these are also referred to as long-term liabilities. 

Non-current liabilities are used to derive crucial metrics that help in identifying the quantifiers that signify a company’s financial standing. For instance, the long-term debt to total assets ratio helps in understanding to what extent a business is depending on its borrowings to fund its capital operations.     

A low percentage implies that the company does not depend heavily on its borrowed capital. Here are some non-current liabilities examples: deferred tax payable, mortgage loan, debentures, derivative liabilities, bonds, etc. 

Analysts determine the bankability of a company with its ability to pay off its non-current liabilities with its future earnings. In other words, the non-current liabilities of a company are quintessential for identifying its long-term solvency. Hence, investors prefer taking a closer look at the long-term liabilities of organizing before taking any investment decision.    

Non-current liabilities = Long term borrowings + Secured and unsecured loans + deferred tax liabilities + Other non-current liabilities

  • Contingent Liabilities

Contingent liabilities refer to the obligations that may or may not arise in the future. These are recorded in the books if there are over 50 percent chances of it occurring in the future. One such example of contingent liability is a lawsuit. For instance, if a business is facing a lawsuit of ₹5 lakhs then the company would incur liability if and only if the lawsuit is proven to be successful. If the lawsuit remains unproven, then liabilities would not arise. 

Financial Liabilities:

 Financial liabilities serve like credit cards for any business. Although the money comes in handy for financing business-related activities, one should be mindful that excessive liabilities can put a dent in a balance sheet of a company and push it to the verge of bankruptcy.      

Financial liabilities are generally legally enforceable due to an agreement entered by two entities. They can also be equitable obligations such as duty based on moral or ethical considerations. It can also be binding depending on the entity and the set of circumstances around an obligation. Almost all financial liabilities are recorded on the balance sheet of the entity.

Importance of liabilities and their impact on business:

Although liabilities indicate future obligations, they are a vital aspect of the operations of a company. These are primarily used in financing the operations and paying for the major expenses necessary for expanding the operations. 

Liabilities also make business transactions smooth and efficient. For instance, if a company has to make small payments for every little purchased quantity each time a material is delivered, it would have to make several repeated payments within a short span. However, if the company gets billed for its purchases from a particular supplier over a quarter or a month, then it would clear all the payments owed to the supplier in a minimal number of transactions. 

All liabilities come with a date of maturity on which they become due. Once they become due, they can prove detrimental to any business. Delaying or defaulting any liability further adds more liabilities to the balance sheet in the form of taxes, increased interest rates, or fines. Such events can also result in damage to the reputation of a company.

In summary:

 An investor must understand what is the meaning of liability to assess the financial health of a company. Although liabilities are looked upon as unfavorable as they always result in the payout of any asset or cash, it is essential to realize the overall impact they have on any business. The people impacted by financial liabilities are equity research analysts, investors, and those who are involved in the business of selling, purchasing, and offering advice on the shares and bonds of a company. This is the reason why experienced investors take a good look at the liabilities while carrying out the analysis of the financial health of any company they are keen on investing in.

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