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Definition of a Liability:
is a debt or obligation that needs to be repaid.
A liability is a claim against assets because it must be repaid, and usually the source of repayment is an individual’s or company’s assets. For example, when a household receives an electric bill, the amount owed is a liability. It is paid using a family’s asset, most likely cash. Businesses incur liabilities in their ongoing activity. A business may secure a bank loan to fund the expansion of a plant or acquire equipment. The borrower has a responsibility to repay the loan. Repayment requires economic sacrifice since cash or some other asset is used to make payments. Three types of liabilities are: current liabilities, long-term liabilities, and contingent liabilities.
Current liabilities are due in less than one year. The electrical bill mentioned above is a current liability. Other current liabilities include accounts payable to vendors, wages payable to employees, or taxes payable to the government. A loan or a portion of a loan that is due in one year is also a current liability.
Long term liabilities are debt obligations that exceed one year. They include mortgages, long-term bank loans, and bonds that are issued by a corporation or government. (A bond is an asset for the entity that purchases it, but a liability for the party that sells the bond.)
Contingent liabilities include potential obligations that may impact a company’s financial health. For example, if it is probable a company will lose a lawsuit, the estimated settlement would be listed as a contingent liability. Assume a former employee is suing Bill's Grill for negligence after suffering burns. His estimated settlement is $500,000. Bill's Grill would have a contingent liability of $500,000.
Liabilities are listed on the right side of a balance sheet. A balance sheet can be broken into three components: assets, liabilities, and financial equity. The sum of a company’s liabilities and financial equity must equal its assets since the value of a company (equity) equals the sum of its assets minus what it owes (its liabilities). For example, assume Tye’s Laundry has $700,000 in assets and $470,000 in debts. Tye has $230,000 in financial equity in the company. This is reflected on Tye's balance sheet where all of his assets are listed on the left side, and the liabilities and financial equity are listed on the right side. Tye’s Laundry has the following assets:
Land and Buildings $500,000
Tye’s Laundry has the following liabilities:
Washers and Dryers $170,000
Total Assets $700,000
Wages Payable $50,000
Taxes Payable $20,000
Equipment Loans $150,000
Mortgage Balance $250,000
Total Liabilities $470,000
Tye’s ownership interest, or financial equity, equals $230,000 (assuming Tye is the only owner).
When expressed on a balance sheet, the financial statement would be:
When a business borrows money, the loan amount is a liability, but the cash from the loan immediately becomes an asset. If Tye’s Laundry borrows $100,000 to purchase equipment, Tye’s equipment loans would increase by $100,000, but his washer and dryer’s account on the asset side would also increase by $100,000. His financial equity would remain unchanged. If Tye had financed the purchase of the washers and dryers by investing more of his own money (not Tye's Laundry's money), the assets and financial equity balances would increase by $100,000. This is because his investment adds $100,000 of equipment to the asset side. He has not borrowed any money, so Tye's Laundry's liabilities would be unchanged. The difference is reflected in the financial equity since the value of the company has increased $100,000. Finally, assume that Tye generates a $10,000 profit. As an owner he receives the profit, so the profit is added to the financial equity, assuming he leaves his profits in the company.
Financial analysts and bankers look closely at the relationship between a company’s liabilities and its assets when choosing a company to purchase stock in or issue a loan to. For example, a company may have difficulty meeting its obligations if its short-term liabilities exceed its short-term assets. A company with no debt is in a better position to weather any future recessions or hardships than a company saddled with a large amount of debt.
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