A liability is a claim against the assets of a business, and liabilities may be current or noncurrent (long-term). Liabilities are a component of the balance sheet formula, which is used to generate the balance sheet financial statement.
Successful business owners must carefully manage liabilities so that the company can maintain a sufficient cash balance for operations.
Balance Sheet Components
The three components of the balance sheet are driven by the balance sheet formula:
Assets – liabilities = equity
A balance sheet provides detail for each of these categories:
- Assets: Assets are defined as resources that are used to generate revenue (sales) and profits in the business. An asset may be tangible, such as a vehicle, or intangible, such as a patent or other intellectual property.
- Liabilities: Liabilities represent amounts owed to other parties, including accounts payable and long-term debt.
- Equity: Equity (also referred to as stockholder’s equity) is the difference between assets and liabilities, and equity includes common stock, additional paid-in capital, and retained earnings. The equity balance is the true value of a business.
Creditors (those who are owed money), and investors each have a claim on the assets of a business. The total dollar amount of claims equals the total asset balance. A company with $500,000 in total assets, for example, may have $270,000 in liabilities and $230,000 in equity.
The balance sheet formula must stay in balance, regardless of the number of transactions posted, or the dollar amount of accounting activity.
Current vs. Non-Current
Liabilities are either current or non-current. A current liability, such as an accounts payable balance, represents bills you must pay within 12 months. Long-term debts, on the other hand, are non-current liabilities. Both accounts payable and long-term debt are common account balances for most businesses. Here are some other liabilities that are less common:
- Current portion of long-term debt: Principal and interest due on a loan payment within the next 12 months are considered a current liability. If a business must pay $20,000 in principal and interest on an equipment loan within a year, for example, that $20,000 is reclassified from long-term debt to a current liability.
- Contingent liabilities: The dollar amount of a contingent liability is dependent on a future event, and this type of liability is based on an estimate. A liability for warranties is a good example. Assume that a sporting goods company sells 10,000 baseball gloves for $50 each and that each glove has a one-year warranty. Based on past experience, the manufacturer estimates that 2% of the gloves (200) will be returned under the warranty and that it will cost $20 to repair each glove and ship it back to the customer. The firm records a warranty liability for (200 gloves X $20 per unit), or $4,000. If the actual warranty liability is different than the estimate, an adjustment is posted in the accounting records.
- Customer deposit: If a business receives a cash deposit from a customer before the product or service is delivered to the client, the dollar amount of the deposit is a current liability. If the baseball glove manufacturer receives a $5,000 deposit from a sporting goods store, for example, the manufacturer increases cash and increases a current liability account called customer deposits. When the goods are shipped to the customer, the liability account is reduced, and revenue is increased to record the finalized sale.
Almost all contingent liabilities and customer deposits are current liabilities because the liability will be removed within 12 months.
Balance Sheet Impact
Every liability accounting entry impacts the balance sheet, and these are some common liability transactions:
- Purchase on credit: A purchase made on credit means that the buyer does not pay cash, and most credit purchases increase a current liability account. If the glove manufacturer purchases leather material on credit, the firm increases as asset account for the material and increases accounts payable.
- Paying a liability: When a liability is paid, both the liability account and the cash account are reduced. Cash can be used to reduce either a current liability or long-term debt. Paying off a loan due in three years, for example, removes a non-current liability.
- Non-cash transactions: Some liability transactions do not involve cash. Assume, for example, that the glove manufacturer owes a vendor $7,000 for leather material, and that the amount is posted to accounts payable. The vendor agrees to accept a piece of the manufacturer’s equipment as payment for the amount owed. In this case, the manufacturer would reduce the equipment asset account, and reduce accounts payable for $7,000.
To keep these transactions straight in your mind, remember that the balance sheet formula must always stay in balance. Every liability transaction must meet this requirement.
Your business requires a specific amount of cash to operate each month, and you need to track your liabilities and your cash payments so that the company can maintain a sufficient cash balance.
You should create a formal budget for each year, and your budgeting process must include an analysis of your firm’s liabilities, and how those liabilities will be paid. The easiest way to budget is to estimate annual sales, and then compute the total costs required to create your product or service. Consider this example:
- Estimating sales: A baseball glove manufacturer plans to manufacture and sell 50,000 baseball gloves and a cost of $35 per glove. The company does not have any inventory at the beginning of the year, so the firm will manufacture all of the gloves sold during the year.
- Computing costs: The manufacturer budgets for each cost required to make a glove, and the company determines that it needs $20 of leather material per glove, or $1,000,000 in leather material for 50,000 gloves.
- Ordering, payment: The company assumes that glove production will peak during January through March, in order to meet customer demand in the spring and summer. The firm’s budget assumes $200,000 in leather material purchases each month for the first three months of the year. The leather vendor requires payment within 30 days, so the manufacturer must pay $200,000 in February, March, and April for the purchases.
The business will create a $200,000 current liability to pay for leather material each month during the first quarter, and the firm needs to decide how the liabilities will be paid. To answer this question, management creates a cash flow forecast, which considers liabilities owed, cash inflows from sales, and other factors.
Creating a budget forces a business to consider estimated sales, production costs, and cash flows. Your budget is a tool to manage each aspect of your company, including liability management. Invest the time to create a formal budget each year.