In the finance world, liabilities are often viewed as a necessary evil. Essential for growth, yet burdensome, sometimes catastrophic, if mismanaged. But what exactly are liabilities, and how do they influence a company’s finances?
Here are some basics about liabilities, and be sure to reinforce your learning with our free quiz at the end!
What Are Liabilities?
Liabilities are present obligations of an entity to transfer an economic resource that can produce future benefits due to past events. If you took out a bank loan (the past event), you must repay it (the present obligation to transfer) with cash (the economic resource that can produce future benefits).
In simpler terms, liabilities are things you owe.
Like assets, liabilities are categorised into current and non-current liabilities. The difference is the grouping criteria.
Assets are categorised into current and non-current assets based on liquidity (how fast they can be converted to cash), and liabilities are grouped into current and non-current liabilities based on maturity (when they need to be settled).
Current Liabilities
Current liabilities are debts and other obligations due to be settled within a year or the company’s operating cycle. They are short-term financial obligations a business must pay off in the near term, typically using its current assets like accounts receivable and cash.
Some examples of current liabilities include:
| Current Liability | Explanation |
| Accounts payable | Money owed to suppliers for goods and services received, but not paid for. Accounts payable are the most common current liability. |
| Short-term debt | Bank loans and other borrowings due to be paid within a year. |
| Taxes payable | Taxes owed to the government that are due in the current year. Taxes payable usually include balances for income tax, sales tax and payroll tax. |
| Accrued expenses | Expenses that have been incurred but not paid for. Accrued expenses usually include balances for wages, utilities and interest payable. |
These four examples commonly appear on a company’s statement of financial position, with short-term debt only appearing if the company has long-term debt. Additional current liabilities – like deferred revenue and dividends payable – may be presented, depending on the company.
Included in short-term debt is a company’s current portion of long-term debt – the part of its long-term debt that is repayable annually, according to the debt repayment structure. If a company takes out a £2,000,000 loan with annual repayments of £50,000, £50,000 becomes the current portion of long-term debt due each year and is included in the company’s short-term debt figure.
Non-Current Liabilities
Non-current liabilities, also called long-term liabilities, are financial obligations not due to be settled within a year or the company’s operating cycle. They represent the long-term debt and other financial commitments to be paid off over an extended period, often several years.
Some examples of non-current liabilities include:
| Non-Current Liability | Explanation |
| Long-term debt | Bank loans and other borrowings due for repayment over a period extending beyond one year. |
| Lease liabilities | Payment obligations on capital and finance leases that extend beyond one year. |
| Deferred revenue | Money received for goods or services to be delivered beyond the next 12 months. |
The three examples in the table above appear most often on statements of financial position, with long-term debt only appearing if the company borrows.
Some other non-current liabilities include pension liabilities (commitments to pay pensions to employees after retirement) and deferred tax liabilities (taxes owed but not due for payment within the current year).
Operating Liabilities vs Financing Liabilities
Operating and financing liabilities are two distinct categories of liabilities a company incurs, each serving different purposes and arising from contrasting business activities.
Operating liabilities are obligations a company incurs as part of its normal operations. These liabilities arise from day-to-day business activities such as purchasing inventory on credit (accounts payable) and paying employees (accrued expenses). Because operating liabilities are short-term by nature, most operating liabilities are current liabilities.
Financing liabilities are obligations arising from a company’s financing activities, typically those related to the funding of long-term growth, investments and expansion. Because of their long-term nature, most financial liabilities are non-current liabilities, such as long-term debts and lease liabilities.
Operating and financing liabilities also impact a company differently. Operating liabilities affect a company’s working capital and short-term liquidity, while financing liabilities affect its capital structure and long-term financial health.
Working capital refers to a company’s current assets and current liabilities. These ensure the day-to-day running of the business. Since current assets are typically used to pay for current liabilities, companies usually maintain a lower current liability balance to avoid liquidity issues (not being able to convert current assets to cash quickly enough to cover current liabilities when they fall due).
Capital structure refers to a company’s makeup regarding debt and equity – how much debt versus equity is used to finance the company’s entire operation. Taking on manageable amounts of debt to fund growth and expansion is generally accepted, especially if the debt doesn’t significantly alter the company’s capital structure. When borrowing gets excessive and unmanageable, it can lead to long-term financial health issues and potentially catastrophic consequences (bankruptcy).
Ensuring that operating and financing liabilities remain manageable relative to the company’s assets is crucial to maintaining short-term and long-term financial health.
The following table summarises the differences between operating liabilities and financing liabilities.
| Difference | Operating Liabilities | Financing Liabilities |
| Business activity | Related to the day-to-day functioning of the business. | Related to raising capital for long-term growth and expansion. |
| Duration/Nature | Short-term, mainly consisting of current liabilities. | Long-term, mainly consisting of non-current liabilities. |
| Financial Impact | Affects the company’s working capital and short-term liquidity. | Affects the company’s capital structure and long-term financial health. |
Impact of Liabilities on Financial Performance
Liabilities, particularly long-term debt, positively and negatively impact a company’s financial performance because of the associated interest expense.
Alongside the higher revenues and profit from long-term growth and expansion, companies may take on debt for another reason: tax deductions. When a company takes on debt, it incurs interest expenses that must be paid regularly. These interest payments are expensed in the company’s statement of profit or loss, reducing its taxable income and resulting in tax savings and improved profitability.
However, there is a fine line between a company’s interest expense improving profitability versus eroding it.
Since interest payments are expensed in the statement of profit or loss, they reduce a company’s taxable profit and, consequently, its profit for the year. When a company takes on excessive debt, it can lead to substantial interest obligations that eat into its earnings.
Of course, the higher interest expense can lead to higher tax savings. But at what cost?
What happens when the interest expense goes from being a helping hand to a burden? What happens when the interest expense becomes unaffordable, and the company goes from generating £100 million in profit to £50 million in losses?
What then?
Summary
Liabilities are an entity’s present obligations to transfer an economic resource that can produce future benefits due to past events. In simpler terms, liabilities are things you owe and are most commonly categorised as current or non-current based on maturity.
Liabilities can also be grouped as operating liabilities (liabilities arising from the company’s day-to-day operations) or financing liabilities (liabilities related to the funding of a company’s long-term growth and expansion).
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