A liability is something a person or company owes, most commonly a sum of money. Liabilities are usually settled over a specified period of time through the transfer of economic benefits such as money, goods or services.
When a company has liabilities they are recorded on the right-hand side of a balance sheet and may include loans, mortgages, accounts payable, deferred revenues, bonds, warranties, and accrued expenses.
How a liability works
A liability is an incomplete obligation between two parties. There are two main categories of liabilities, current and non-current. Current liabilities are often short-term liabilities that are expected to be concluded within 12 months, whereas non-current liabilities are long-term and are not expected to be concluded for 12 months or more.
An example of a current liability would be dividends payable and an example of a non-current liability would be bonds payable. Liabilities play an important role in the company as they are used to finance operations and pay for expansion.
Many companies will have current and non-current liabilities on their balance sheet. For example, a mortgage would be considered a non-current liability. But the repayments during the next 12 months would be considered a current liability as they are due in the short term.
Types of liabilities
Analysts want to see that a company can pay current liabilities with cash to help determine whether their short-term liabilities present a risk. Examples of current liabilities include:
- Wages payable – The amount of income employees have earned but not yet received.
- Interest payable – This represents the interest on short-term credit purchases.
- Dividends payable – For companies that have issued stock to investors and pay dividends, this is the amount owed to shareholders after the dividend is declared.
- Unearned revenues – This is a company’s liability to deliver goods or services at a later date after being paid in advance.
When it comes to non-current liabilities, analysts want to see that they can be paid with assets derived from future earnings or financial transactions. Examples of non-current liabilities include:
- Warranty liability – This is the estimated amount of time and money that may be spent repairing products under the agreement of a warranty. Most common in the automotive industry as cars usually have a long warranty period.
- Contingent liability evaluation – A liability that may occur as a result of the outcome of an uncertain future event.
- Deferred credits – This is a broad category but is basically revenue collected before it has been earned and recorded on the income statement.
- Post-employment benefits – These are benefits payable to an employee or their family when they retire.
Advantages of Liabilities
The advantages of liabilities include:
Can help companies raise finances
Companies that are experiencing cash flow issues can use their liabilities in their favor to improve liquidity and help them raise finances.
Companies maintain ownership
When a company wants to raise funds for growth it will typically sell shares or seek an angel investor, but a downside to this method is that they lose equity in the company. But leveraging long-term liabilities such as loans or mortgages can help them retain full ownership.
Disadvantages of Liabilities
The disadvantages of liabilities include:
Can be costly for companies
Cash paid through interest can have a devastating impact on a company if it is not doing well. Amid tough economic conditions, companies may not be able to keep up with the annual interest payment.
May lead to a low credit rating
Companies that have a high level of debt may also have a lower credit rating which will not only affect their future borrowing power but also may deter investment.