In this article, we are going to discuss another common term associated with insurance- 'liability'. We will define this term from the point of view of business insurance. After going through this article, you will have a clear idea about what liability is, what the different types of liability are, and how they differ from assets.
Let’s start with the basics then!
What are the liabilities?
Liability refers to something (typically a monetary amount) that an individual or a company owes. Liabilities are settled during a time period by transferring financial benefits such as money, goods, or services. Liabilities are recorded on the right-hand side of a balance sheet. They include accounts payable, mortgages, loans, warranties, delayed revenues, bonds, and accrued expenses. Liability, in general, describes the state of being accountable for anything and it can relate to any amount or service due to another party. For example, the tax liability can relate to property taxes owed to the Government or income tax authorities by a homeowner. In another example, liability can refer to one's prospective damages in a lawsuit.
Liabilities and assets are reflected in opposition in company books. Liabilities are things you have borrowed or owe, whereas assets are things you own.
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What are the different types of liability?
Broadly speaking, there are two types of liabilities - Current (Short-Term) Liability and Non-Current (Long-Term) Liability.
- Current or Short-Term Liability
Current liabilities are debts due within a year, which are primarily paid in cash. Analysts prefer that a business can cover its current liabilities. Payroll expenses and accounts payable are examples of such liabilities. These may include money due to vendors, monthly utilities, and other similar expenses. Other examples are:
- Interest payable
Businesses, like individuals, frequently use credit to fund the acquisition of products and services over short periods of time. They need to pay interest on these short-term credit purchases.
- Wages payable
This is the total accrued income earned but not yet received by employees. Because most businesses pay their employees monthly, this liability changes frequently.
- Dividends payable
This is applicable to companies that have issued shares to investors and pay a dividend. The dividends payable indicate the amount owed to shareholders after the dividend was announced.
- Liabilities of discontinued operations
This is a one-of-a-kind liability that most people overlook but should pursue further. Companies must evaluate the financial impact of a division, operation, or entity that is up for sale or has been sold recently. This includes the monetary impact of a product line that has recently been discontinued.
- Unearned revenues
This is a company's obligation to supply goods and/or services at a later date after receiving advance payment. Once the product or service is provided, this sum will be lowered with an offsetting entry.
2. Non-Current or Long-Term Liability
Given the name, it is evident that any liability that is not immediate comes under non-current liabilities. these are usually scheduled to be paid in more than 12 months. For example, if a company takes a 15-year mortgage, it is considered a long-term liability. Long-term liability also referred to as bonds payable is typically the most significant liability and appears at the top of the priority list.
Analysts are looking for evidence that long-term liabilities may be settled with assets acquired from future revenues or financing transactions. Bonds, loans, Rent, wages, deferred taxes, and pension obligations are all examples of long-term liabilities. Other examples are:
- Deferred credits
This is a vast category that can be categorized as either current or non-current depending on the details of the financial transactions. These credits are effectively the revenue collected before it is shown on the income statement as earned. Deferred revenue, customer advances, or a transaction in which credits are owed but not yet recognized as revenue are all examples of it. When the income is no longer delayed, this credit is deducted from the sum earned, and it becomes a part of the company's stream of revenue.
- Warranty liability
Some liabilities must be estimated since they are not as precise as accounts payable. It is the projected amount of money and time that will be spent repairing products if a warranty is agreed upon. This is a typical liability in the automobile industry, as most vehicles have lengthy warranties that can be quite expensive.
- Post-employment benefits
These are retirement benefits that an employee or family member may receive, which are carried as long-term liabilities as they accrue. With rising healthcare costs and deferred compensation, this liability should not be neglected.
- Contingent liability evaluation
A contingent liability is one that may arise due to the outcome of an uncertain future occurrence. It is an obligation that may have to be met in the future, but there are still issues that make it a possibility rather than a certainty. Suits and possible lawsuits are the most typical examples of contingent liabilities, although product warranties, unused gift cards, and recalls are also included.
- Unamortized Investment Tax Credits (UITC)
This is the difference between an asset's original cost and the amount already depreciated. The unamortized component of the asset is a liability, but it is merely an approximate estimate of its fair market worth. For an analyst, this provides information on how proactive or conservative a company's depreciation techniques are.
Companies will categorise their liabilities depending on when they are due. Current liabilities are those that are due within a year and are frequently paid using current assets. Non-current liabilities are those that are due in more than a year and typically involve debt repayments and deferred payments.
How does liability work?
In general, a liability is an unfinished or unpaid obligation between two parties. Liabilities are classified as current or non-current based on their timeliness. They can be a future service owed to others (short-term or long-term borrowing from banks, individuals, or other institutions) or a previous transaction that leads to an unresolved obligation. Accounts payable and bonds payable are two of the most common liabilities. Most businesses will include these two items on their balance sheets because they are a part of the current and long-term operations.
Liabilities are an important part of a business because they are utilised to fund operations and big expansions. They can also improve the efficiency of business transactions. For example, if a supplier sells certain items to a restaurant, it usually does not require payment when the goods are delivered. Instead, it bills the restaurant for the purchase in order to expedite the drop-off process and make payment easy for the restaurant. Here, the restaurant's outstanding debt to its supplier is classified as a liability. The supplier, on the other hand, considers the money owed to it as an asset.
Liabilities and assets
Assets are things that a company owns. It may include tangible objects such as buildings, machinery, and equipment, as well as intangible items such as interest owed, accounts receivable, patents, or intellectual property. When a company's liabilities are subtracted from its assets, the difference is known as the owner's or stockholders' equity. This relation can be stated with an accounting equation as follows:
- Assets−Liabilities=Owner’s Equity
- However, in most cases, it is commonly presented as -
- Assets=Liabilities+EquityAssets=Liabilities+Equity
This formula can be rearranged to read liabilities = assets - equity. As a result, the value of a company's entire liabilities equals the difference between its total assets and shareholders' equity. If a company increases its liabilities without increasing its assets, the value of the company's equity position must decrease.
Liabilities and expenses
An expense is the operational cost incurred by a business in order to earn revenue. Expenses, unlike assets and liabilities, are tied to revenue and are both shown on a company's income statement. In a nutshell, expenses are utilised to compute the net income. Net income is calculated by subtracting revenues from expenses. For example, if a company has had higher costs than income for the previous three years, it may indicate a lack of financial stability because it has been losing money during that time.
Expenses and liabilities should not be used interchangeably. One appears on the balance sheet of a company, while the other appears on its income statement. Expenses represent the costs of running a business, whereas liabilities are the debts and obligations owed by the business. Expenses might be paid in cash right away. They can also be postponed, resulting in liability.
How is business liability analysed?
A company can evaluate if it has too much debt by comparing it to other liquidity and solvency metrics, such as the debt-to-equity ratio, current ratio and debt-to-asset ratio.
- Current Ratio
This liquidity ratio assists a company in determining whether it is able to pay its short-term debt and fulfill its cash requirements, based on its present assets and liabilities. To get the ratio, you will need to divide the current assets by the current liabilities. A ratio of 2 or higher is considered optimal, whereas a ratio less than that may indicate poorer liquidity and lower short-term payment capabilities.
For example, a business with Rs 8,40,000 in current assets and Rs 4,20,000 in current liabilities should be able to comfortably pay down its short-term debt, as its current ratio is 2.
- Debt to Equity ratio
The debt-to-equity ratio, or D/E ratio, of a business is a measure of its ability to cover its debt. It is computed by dividing the total debt of the business by its total shareholders' equity. The greater the D/E ratio, the more difficult it may be for the company to cover all of its liabilities, as it indicates that the company's debt is rather large in comparison to its assets. It can assist a business owner in determining if shareholders' equity is sufficient enough to cover all debt if the business suffers a fall.
A ratio of less than two is generally preferable, but an ideal ratio is industry-specific. High-performing capital goods firms, for example, have a debt-to-equity ratio somewhat higher than one. Less capital-intensive industries (technology, for example) have a ratio closer to 0.60. If these ratios are exceeded, a business owner in the respective industries should consider debt reduction.
- Debt to asset ratio
Another solvency ratio is the debt-to-asset ratio. It compares the total debt (including long-term and short-term) to total business assets. It determines whether you have adequate assets to sell in order to pay off your debt, if necessary.
To preserve borrowing capacity and avoid being overly leveraged, a debt-to-asset ratio of no more than 0.3 is desirable. After all, some assets cannot be sold at their balance-sheet value. Customers' amounts due to the company, for example, may not be collected.
The footnote: We hope the discussion above will help you understand what the term ‘liability’ means from the point of view of business insurance.
