Liabilities are anything that your business owes to anyone — banks, suppliers, your own employees or even your clients if they launch a lawsuit against your business and the court obliges you to pay. Theoretically, there can be a scenario when your company does not have any debts, but it is uncommon. You must keep track of your liabilities as part of your bookkeeping and your balance sheet is the place to find, analyse and calculate them.
Such terms as assets and equity go together with liabilities of a business in the accounting world, so we will cover them as well.
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Types of liabilities
The balance sheet gathers all the liabilities your business has and divides them into the current and long-term ones.
Current liabilities are those that you must pay back within a year or less. By the way, they help you to define the liquidity of your business, or how quickly you can pay off all your debts, using only the current liabilities.
So, here is what the current liabilities include:
- Accounts payable, or the money you owe to your suppliers. These payments are usually due in 30 days. Accounts payable are contrary to the accounts receivable — the money your customers owe you. On a balance sheet, accounts payable are in the liabilities section, and accounts receivable are in the assets section.
- Bank loans, which include loan principals and loan interests.
- Salaries are considered to be current liabilities if they remain unpaid at the end of your company’s reporting period.
- Taxes. This is not only about the taxes you owe for the current year, but also your previous year debts to the tax authority (if you have any). Current liabilities include all types of taxes your business might have (income tax, capital tax and self-employment tax). If you have an interest on the taxes or penalties you have not paid off yet, they are also seen as current liabilities.
Long-term liabilities are the debts that can wait to be paid off for more than a year.
- Loans that are due to be paid more than twelve months from now.
- Deferred tax liabilities. Such liabilities are the difference between what your company pays in taxes and the amount it actually owes. For example, you make one tax assessment of your company when you file your financial statement to HMRC, and then it sends back to you another estimation — which turns out to be as more accurate as bigger. This also has a pair in the assets club — a deferred tax asset, which is when you pay more in taxes than you actually owe. For this, you can claim tax credits.
- Pension obligations.
- Any other payments, expected to be covered in more than a year. This might include lease payments, mortgage, equipment and other capital payments.
Your business might also have so-called contingent liabilities — that is something you might have to pay depending on the outcome of any event, such as the results of a pending investigation or product warranties spendings.
Your liabilities, assets, equity
Liabilities are one of the main components of the balance sheet, together with assets and equity.
What is what?
- The assets are how much you have.
- The liabilities are how much you owe.
- The equity is how much you and any other investors have put into your business by now.
In terms of counting, you can gather all of it in the following formula:
Assets = Liability + Equity
The balance sheet usually puts the assets to the left, and the liabilities and equity — to the right. However, they might also go in one column.
Cash — $2,050
Accounts receivable — $6,100
Inventory — $900Total assets — $9,050
Accounts payable — $150
Wages payable — $2,000Total liabilities — $2,150
Common stock — $5,000
Retained earnings — $10,900
Drawing — −$9,000
Total equity — $6,900
The debt ratios
You can measure how much a burden of liabilities (debts) of your company is by accounting ratios — the debt ratio and the long-term debt ratio.
The debt ratio puts your total liabilities against your total assets and counted by dividing them and multiplying by 100 to get a percentage figure. The lower the ratio, the less leveraged (meaning in debt) your company is and the easier it is for it to cover its debts. However, the industry and figures your competitors have are also factors to take into account.
Say, a company has £5,000 of liabilities and £15,000 of total assets. The debt ratio is
£5,000 / £15,000 x 100 = 33,3%.
The difference of the long-term debt ratio from the debt ratio is that it leaves the current liabilities of your company out of the counting. So, the formula will be long-term liabilities / total assets x 100. This ratio shows how much your business relies and depends on its long-term debts and if the ratio goes down, it is seen as a good sign, meaning your company grows without relying on them too much.
Say, a company has £5,000 of long-term liabilities and £20,000 of total assets.The long-term debt ratio will be
£5,000 / £20,000 x 100 = 25%
Public liability insurance
Your company may be liable not only to pay its debts or taxes. A member of the public can suit your company and if the court decision rules that you owe the money to the member of the public, you will be liable to cover the costs of the damage your business caused. If your company is a private limited one, then this will be not your personal liability, but that of your business. Public liability insurance covers such costs for your business. Businesses that involve frequent interaction with its clients usually choose to have PL insurance to be saved from possible risks.
Gavin has a hotel and also owns a shopping mall. He has been paying for his public liabilities insurance from the beginning of this business.
One day a guest at the hotel seats on the chair in his room which is broken and breaks his leg and sues the hotel to cover the costs for recovering. Public liability insurance helps Gavin.
The next day a roof of his shopping mall collapses and one of the visitors gets a concussion. Another lawsuit for Gavin, with the costs being covered by the public liability insurance he has.
Public liability insurance usually covers:
- Injuries as described in example with Gavin and his premises.
- Property damage for the business like roofers or carpenters. Say, a roofer does his job and breaks a window of the client’s house — public liability insurance covers the costs.
- Legal expenses of your business, for example, if you get a lawsuit and want to hire an attorney to represent your company in court — the insurance will help you.
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