Table of Contents
Liabilities are debts that a company owes to another business, organization, vendor, employee, or government agency. Unless you’re running an entirely cash-based business, your company probably has liabilities. The most common types of liabilities are accounts payable and loans payable.
Liabilities can make purchasing items for your business easier because they allow you to acquire goods and services without paying for them right away. They may also help you finance your company. For example, a small business loan is a liability that can help you grow your business. As you pay off the loan, you can use the borrowed money to improve and expand your business and increase profits.
Too much of a good thing (in this case, debt), however, can spell trouble for a small business. A proper balance of liabilities and equity provides a strong foundation for a company. Here’s a closer look at business liabilities and how they work.
Key Points
• Business liabilities are amounts a company owes, such as loans, accounts payable, wages payable, and deferred revenue.
• Liabilities are recorded on the right side of a balance sheet and are categorized as current (short-term) or non-current (long-term).
• Current liabilities are typically due within one year, while non-current liabilities extend beyond one year.
• Taking on liabilities can help finance growth, but too much debt may strain cash flow and financial stability.
• Financial ratios like the current ratio and debt-to-equity ratio can help assess whether liabilities are manageable.
What Is a Liability?
Business liabilities are defined as the amounts owed by a business at any one time. They’re often expressed as “payables” for accounting purposes. Liabilities include small business loans, accounts payable, wages payable, interest payable, and unearned revenue.
Recorded on the right side of a balance sheet, liabilities can be contrasted with assets. While liabilities refer to things that you owe or have borrowed, assets are things that you own or are owed.
Liabilities can fluctuate daily as you add new debt and make payments. The more debts you have, the higher your liabilities are, and the more debts you pay off, the lower your liabilities are.
Recommended: Why Reinvest Business Profits?
Understanding Liabilities in Business
A business liability is created when a company buys an item with something other than cash or a check. Any form of borrowing creates a liability, including the use of a credit card.
You also create a liability if you take out a business loan or a mortgage on a business property, use a line of credit, or get a bank overdraft. In addition, your business can have liabilities from activities like paying employees and collecting sales tax from customers.
Some liability is good for a business to use as leverage, which is the use of borrowing to increase the potential returns of a project. For example, if your coffee shop gets more customers than it can hold in its current space, using a loan to expand allows you to serve more customers and increase profits, potentially generating returns that exceed the cost of the loan.
On the other hand, too much liability isn’t good for business. If too much of a company’s income is spent on paying back loans, there may not be enough to cover other expenses. That’s why it’s important to keep track of liabilities and analyze them.
Recommended: A Guide to Invoice Financing
Types of Business Liabilities
Business liabilities are grouped into two buckets: current (or short-term) and non-current (or long-term). Current liabilities are debts that are expected to be paid off within a year, while non-current liabilities are debts that are payable over longer than one year.
Current Liabilities
Here are some examples of current liabilities:
• Principal and interest payable: This includes any payments due toward a mortgage or small business loan that are due within the year.
• Short-term loans: These are loans that are due within 12 months, such as a business line of credit, short-term working capital loans, or bank overdraft.
• Accounts payable: This represents debts owed to vendors, utilities, and suppliers purchased on trade credit, which may be due in 30, 60, or 90 days. Until paid, these are considered short-term liabilities.
• Taxes payable: Both state and income taxes are due within a year, making them short-term liabilities.
• Unearned revenue: This typically refers to cash that a firm receives before it delivers goods or renders a service. The company’s liability is to deliver goods and/or services at a future date.
• Wages payable: This includes the total amount of accrued income employees have earned but not yet been paid.
Non-Current Liabilities
Here are some examples of a company’s non-current liabilities:
• Long-term notes payable: Notes payable are very similar to accounts payable except for the length of the terms for payment. When a formal loan agreement has payment terms that go beyond one year, such as the purchase of a company car or different types of business loans, it is a note payable.
• Deferred taxes: While taxes are usually considered a short-term liability, there are times when they need to be deferred for longer than a year.
• Mortgage payable: Mortgages are considered a long-term liability and are recorded as mortgage payable on the balance sheet. The monthly principal and interest payments due, however, are considered current liabilities and are recorded on the balance sheet.
Liabilities vs. Assets
Assets are the things that a company owns or that are owed to the company. Assets include tangible items, such as buildings, machinery, and equipment, as well as intangible items, such as accounts receivable, interest owed, patents, or intellectual property.
When comparing a company’s assets and liabilities, the difference is the owner’s or stockholders’ equity.
The accounting equation is:
Assets – Liabilities = Owner’s Equity
Liabilities and Expenses
While expenses and liabilities may sound similar, they are different.
Liabilities are what you’re obligated to pay, either in the near future or further down the road, to other parties. Typically, it’s money owed for the purchase of an asset with value. For example, you might buy a car for business use. When you finance the car, you end up with a loan, which is a liability. Liabilities appear on the company balance sheet because they are associated with assets.
Expenses, on the other hand, are more immediate in nature. They are what your company pays monthly to fund operations and generate revenue. Expenses also include ongoing payments you make for services, such as phones or electricity. You keep track of your business expenses on your company’s income statement to determine net income. The equation to calculate net income is revenue minus expenses.
| Liabilities | Expenses |
|---|---|
| Paid at a future date | Paid during the current period |
| Recorded on the balance sheet | Recorded on the income statement |
| Offset assets | Offset revenues |
| Used to calculate owners’ or stockholders’ equity | Used to calculate net income |
Liabilities on a Balance Sheet
Liabilities are shown on your business’s balance sheet, which is a financial statement that provides a snapshot of your company’s financial health at a given moment. The balance sheet is designed to display the relationship between assets and liabilities to get a picture of your company’s net worth.
Typically, you find assets (everything your company owns) on the left-hand side of the balance sheet and liabilities, along with owners’ or shareholders’ equity (how much of the company you or your shareholders own), on the right-hand side of your balance sheet.
Recommended: What Is a Classified Balance Sheet?
Pros and Cons of Business Liabilities
| Pros of Business Liabilities | Cons of Business Liabilities |
|---|---|
| Important for growing a business | May be owed even if your business fails |
| Free up cash for immediate needs | May come with high interest rates |
| May offer tax-deductible interest payments | Risk financial strain from too much dependency |
Analyzing Business Liabilities
Here are three key financial ratios that can help you assess whether your liabilities are manageable or need to be lowered.
Current Ratio
This ratio measures whether or not a business has enough resources to pay its bills over the next 12 months. To calculate the current ratio, you divide a firm’s current assets by its current liabilities. A good current ratio is typically considered to be between 1.5 and 3.
Debt-to-Asset Ratio
This ratio measures solvency and tells you what portion of your assets are paid for with borrowed money rather than equity. You calculate it by dividing total liabilities by total assets. A high debt-to-asset ratio indicates that a company may have trouble borrowing more money or may have to pay a higher interest rate on a loan than it would if its ratio were lower.
Debt-to-Equity Ratio
The debt-to-equity ratio can be used to assess the extent of a firm’s reliance on debt. It is calculated by dividing a company’s total liabilities by its total owner’s or shareholders’ equity.
Generally, if a company’s debt-to-equity ratio is high, it indicates that the company is at risk of financial distress (i.e., being unable to meet required debt obligations).
The Takeaway
A business incurs liabilities when it borrows. This includes short-term liabilities, such as sales taxes payable and payroll taxes payable, and long-term liabilities, like loans and mortgages.
A key part of being a successful business owner is being able to manage your liabilities. If your company has too much debt, it may be difficult to pay back should your sales slow. If it has too little debt, it may be a sign that you’re not taking advantage of market opportunities.
You can use the different financial ratios, such as the current ratio and debt-to-equity ratio, to assess whether your liabilities are manageable or need to be lowered.
If you’re struggling with too much debt, you can consider a small business loan to help consolidate your debts into one loan with one monthly payment. This could allow you to pay off your debt faster, save money on interest, and shorten your loan term.
If you’re seeking financing for your business, SoFi is here to support you. On SoFi’s marketplace, you can shop and compare financing options for your business in minutes.
FAQ
What are the main types of liabilities?
Businesses sort their liabilities into two main categories: current (short-term) and non-current (long-term). Current liabilities are debts payable within one year, while long-term liabilities are debts payable over a longer period.
Is it ok for a business to have liabilities?
Yes, all businesses generally need to take on liabilities in order to operate and grow. A proper balance of liabilities and equity creates a strong foundation for a company.
Can you decrease liabilities?
Yes. As you pay off debt, your company’s liabilities decrease.
Photo credit: iStock/dusanpetkovic
SoFi's marketplace is owned and operated by SoFi Lending Corp.
Advertising Disclosures: The preliminary options presented on this site are from lenders and providers that pay SoFi compensation for marketing their products and services. This affects whether a product or service is presented on this site. SoFi does not include all products and services in the market. All rates, terms, and conditions vary by provider. See SoFi Lending Corp. licensing information below.
Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.
Tax Information: This article provides general background information only and is not intended to serve as legal or tax advice or as a substitute for legal counsel. You should consult your own attorney and/or tax advisor if you have a question requiring legal or tax advice.
SOSMB-Q126-032