A liability is a debt or other obligation owed by one party to another party. In more direct terms, it is a payment or obligation for which a company is held liable by another party. Companies primarily increase their liabilities by taking out loans, issuing debt in the form of bonds, or increasing accounts payable. Liabilities are recorded on a company’s balance sheet along with assets and equity. Because a liability is an amount of money that must be paid by some point in the future, it is fair to think of liabilities as being more or less equivalent to debt, with a key distinction being that only some liabilities also carry interest.
Using Liabilities to Increase Capital
Companies take on liabilities to increase their capital in order to finance operations or projects. Unlike raising equity by selling company shares, there is an expectation that any debt a company incurs will be paid back, plus any interest payments due. Because of this, for a company to comfortably accept new debt, its owners must be confident that the investment will increase profits enough to cover the debt expense and then some, in order to come out with a net gain.
Short Term or Long Term Liabilities?
Liabilities can be either short term or long term. Short term liabilities cover any debt that must be paid within the coming year. This includes interest payments on loans (but not necessarily the principal of the loan), monthly utilities, short term accounts payable, and so on. Long term liabilities cover any debts with a lifespan longer than one year. Examples would be mortgages, rent on property, pension obligations, auto loans, and any other large expense that is paid over the course of multiple years.
Define Liability in Simple Terms
When evaluating the performance of a company, analysts like to see that any short term liabilities can be completely covered by cash. Any long term liabilities should be able to be covered by revenue generated over time by assets. Liabilities are not the same as expenses. An expense is a cost associated with doing business, such as COGS or cost of goods sold, depreciation and amortization of assets, and so on. These are recorded on a company’s income statement rather than the balance sheet, and are used to calculate net income rather than the value of assets or equity. Liabilities are distinct in that they are obligations and debts owed, not business costs.
Because liabilities are outstanding balances, they are considered to work against the overall spending power of a company. More specifically, liabilities are subtracted from total assets to arrive at a company’s equity value. Incurring too much debt is risky for a company. If a company incurs an amount of debt that it cannot pay off, it is at risk of default, or bankruptcy. Because of this, investors evaluating whether or not to invest in a company often prefer to see a manageable level of debt on a business’s balance sheet. However, less debt does not always mean a better investment.
Liability Across Industries
What is considered an acceptable ratio of equity to liabilities is heavily dependent on the particular company and the industry it operates in. Some companies that earn a consistently large profit and can easily pay back debts, but that also consistently need to invest in new or improved assets to grow the business might regularly carry large amounts of debt. Companies in the energy sector, particularly oil, are an example. Other companies, such as those in the IT sector, don’t often need to spend a significant amount of money on assets, and so more often finance operations through equity. The ratio of debt to equity is simply known as the debt-to-equity ratio, or D/E ratio.
Learn more tools of liability management in order to mitigate financial risks when you consult with a financial advisor in Claremont, CA. If you live outside the vicinity, please browse through our financial advisor page instead.
About the Author
True Tamplin, BSc, CEPF®
True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.
True is a Certified Educator in Personal Finance (CEPF®), a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.