Definition of Liability:
A liability is an obligation that an individual or business must meet, often involving the payment of money. These obligations are fulfilled over time by transferring economic resources like cash, goods, or services. Liabilities are listed on the right side of the balance sheet and include items such as loans, accounts payable, mortgages, deferred revenue, bonds, warranties, and accrued expenses.
Liabilities represent what a company owed or borrowed. In double entry system liabilities are booked in opposition of Asset.
liabilities are generally an obligations between two parties that remains unpaid or incomplete. In accounting, a financial liability refers to a commitment resulting from previous business transactions, events, sales, or exchanges of assets or services, which are expected to generate economic benefits in the future.
They can involve future services owed to others, such as short- or long-term loans from banks, individuals, or other entities, or stem from past transactions that have created an unresolved obligation.
Based on the period labilities can be classified into two types.
1) Current Liabilities
2) Non Current Liabilities
Current Liabilities
A company can settle its current liabilities, which are due within a year, using cash. Examples of short-term liabilities include payroll expenses and accounts payable, such as amounts owed to vendors, monthly utility bills, and other similar obligations. Some examples are:
Wages payable: Wages When employees earned income providing service but not have been yet paid it is known wages payable. Since many companies pay their employees biweekly, this liability frequently fluctuates.
Interest payable: Interest payable refers to the interest owed on short-term credit purchases that companies make when using credit to buy goods and services. This liability represents the cost of borrowing that must be settled.
Dividends payable: Dividends payable refers to the amount a company owes to its shareholders after declaring a dividend. This applies to companies that have issued stock to investors and regularly distribute dividends.
Discontinued operation: Companies must account for the financial effects of a division, operation, or entity that is either up for sale or has recently been sold.
Unearned revenue: Unearned revenues represent a company's obligation to provide goods or services at a future date after receiving payment in advance.
Non Current Liabilities
Liabilities that are not due in the near term are categorized as non-current liabilities, which are expected to be settled in 12 months or more.
Companies of all sizes finance their long-term operations by issuing bonds, which function as loans from investors who buy the bonds. This line item frequently fluctuates as new bonds are issued, mature, or are called back by the issuer.
Analysts seek assurance that long-term liabilities can be met with assets generated from future earnings or financing activities. Beyond bonds and loans, companies may also incur other long-term liabilities, including rent, deferred taxes, payroll obligations, and pension liabilities.
Essential Financial Ratios Involving Non-Current Liabilities
Some ratios to assessing liquidity risk are as follows:
Debt Ratio: The debt ratio evaluates a company's total debt in relation to its total assets to determine its level of leverage.
In contrast, a higher percentage suggests that the company is highly leveraged, raising its risk of default. A debt-to-total-assets ratio of 1.0 indicates a negative net worth, which significantly increases the risk of default.
Interest Coverage Ratio: The interest coverage ratio measures a company's ability to generate enough income to meet its interest payments. A higher coverage ratio indicates that the company can comfortably manage its interest obligations and has the capacity to take on additional debt.