Balance Sheet Components Part 2: Liabilities
This is part 2 of a 3 part post. To know more check the links below:
What are liabilities?
Liabilities are the obligations of debt repay. In other words, they include the money that the company has borrowed and has to pay back. Just as we had current and noncurrent assets, we also have current and noncurrent liabilities. Can you remember what they mean? Current liabilities are debts that have to be repaid within the fiscal year. Noncurrent liabilities have to be repaid in the long term. Similar to assets, current liabilities come first in the balance sheet. Then, noncurrent liabilities are recorded.
Liabilities are given priority to any other type of debt. Remember that the company has borrowed money from investors to run the business and has to repay them annually through the profit it makes. Investment is money lent by a person or a business to another with the hope of future benefit. And owners expect that benefit. However, before the business divides the earnings between business owners, it is obligated to repay its debt to other people and businesses recorded as liabilities. The following measures indicate to which degree a business is capable of debt repayment:
Current Ratio = current Assets/current liabilities
Quick Ratio = current assets – (inventory, advance payments, orders)/current liabilities
Accounts payable (money owed to other people)
Contrary to what it may seem, having a lot of debt is not that bad. One of the business strategies (of course a risky one) is to increase liabilities. As I mentioned in the previous part, assets come from money that business owners invest plus money borrowed from others (liabilities). If the business is certain it is capable of making a profit doing what is does and need more money to do so, then it may take the risk of increasing its liabilities. This also depends on the interest rate. If the interest rates are low and future conditions are likely to remain the same, it would be logical to do so.
Debt to total asset ratio = total debt/total asset
Total debt to net worth = total debt/net worth
As you can guess from the name, this account included the sales that have been made without the payment being made. Unrealized revenue is also known as accrued revenue. In the accrual system, product sales and transaction are not made at the same time. Usually the purchase is recorded at the time when sales documents are made, but payment is made later. In case a customer fails to pay, the amount will be considered an expense.
Taxes have to be paid based in the activities during the fiscal year. At the end of every year, the profit and loss is determined. If the balance sheet indicates a loss, then no tax must be paid. But if the business has made a profit, according to the law of the country where the business is run, a percentage must be paid to the government. For example, in Iran, %25 of the business profit must be paid as the tax for one year. However, the tax is not paid exactly when it is determined. There is usually a time span allowed for tax payment. Therefore, the amount is recorded as reserve tax in current liabilities.
When a business yields a profit, it has to divide that profit (after you subtract debts and tax) between its business owners or shareholders. The money divided between shareholders is called a dividend. At the end of the fiscal year, the dividend is paid to business owners (shareholders). This amount is recorded as dividend payable.
The last liability included is this post is bank loan repayment. Bank loans require monthly interest payments. The interests paid to banks are recorded as liabilities. The principal is recorded under noncurrent liabilities. The following ratio indicates the number of times the company has the ability to pay loan interest in the current state.
Times interest earned ratio = EBIT/ financial expenses EBIT: earnings before interest and tax
Liabilities can increase the risk and at the same time yield profit, if managed properly. It is crucial for businesses to understand how to manage liabilities relative to assets and owner’s equity, to ensure business security. Ratios can help analysis and understand a business in terms of its activities.