If you run a small business, you may eventually want to expand your operations and grow as your business becomes more and more established. But in order to do that effectively and successfully, you’ll need to have a firm grasp on the liabilities that exist and how they may impact your business.
What Is A Liability?
A liability represents a responsibility that your business has as a result of previous events. Simply put, it is your business’s legal obligations or financial debts that come about over the course of your company’s operations. Basically, a liability is something that you owe someone else that has yet to be paid for or completed. Liabilities can be limited or unlimited, short-term (current) or long-term (non-current).
Typically, liabilities are settled through the exchange of money, goods, or services, and generally include things such as loans, mortgages, earned and unearned premiums, and accounts payable.
The most common types of liabilities are things such as accounts payable or bonds payable, and most businesses will have these items on their balance sheets because they are a part of continuing current and long-term business operations.
Liabilities are a common and important part of a business because they’re used to finance ongoing business operations, cover the cost of expansions, and make transactions more efficient.
Let’s get into a little more detail about the different forms of liabilities that may impact your small business.
Understanding The Different Types Of Liabilities
There are various forms of liabilities that small business owners should be aware of, which include the following.
Current liabilities (short-term) – Also referred to as short-term liabilities, current liabilities represent a business’s financial obligations that must be fully repaid in less than 12 months. Examples of these types of liabilities include short-term loans, staff wages, accounts payable, lease payments, and income taxes payable. Unlike long-term liabilities that typically include financing debt (such as commercial mortgages), short-term liabilities generally involve operating debt required to carry out business operations on a daily basis.
Determining the strength of a company’s performance is important and can be done by assessing the value of short-term debt. Generally speaking, the higher the debt-to-equity ratio, the more a company is leveraging, and therefore the riskier the company is considered to be.
Non-current (long-term) liabilities – Also referred to as long-term liabilities, non-current liabilities are obligations that are listed on a company’s balance sheet that are not due for at least 12 months. These can include things such as long-term loans (such as mortgages), lease obligations, deferred revenues, and bonds payable. For mortgages, the loan itself is considered long-term if the amortization period is longer than one year. But the mortgage payments that are due over the course of the current year are labelled as the current portion of long-term debt.
Long-term liabilities are compared to a business’s cash flow to identify whether or not the company will manage to attain its financial obligations over the long haul. Long-term investors often look at non-current liabilities to determine whether or not a company is over-leveraging. If a company’s cash flow is stable, that’s a good sign that it will be able to handle additional debt with little risk of default.
Contingent liabilities – This type of liability is one that may arise depending on the outcome of a potential future event. If this liability is likely to occur, it is recorded on the balance sheet, along with an estimation of the amount of the liability. An example of a contingent liability can include a pending lawsuit since the outcome of the situation cannot be predicted with 100% certainty.
It should be noted that businesses should understand the difference between a liability and an expense, the latter of which is the cost of operations that is incurred to make money. Expenses are related to revenue and used to calculate a company’s net income, while liabilities are not.
How Liabilities Can Hurt Cash Flow
Your business’s cash flow can be negatively affected by its liabilities, particularly as they relate to your assets. Here are some ways that liabilities may hurt cash flow for your business.
Increase in accounts receivable – If your accounts receivable increases, this could harm your cash flow. Instead, a decrease in accounts receivable can be a good thing for cash flow. Your company’s accounts receivable asset reflects the amount of money that you are still owed by clients who purchased on credit. They’re basically a promise of cash that your company will receive in the future.
Increase in inventory – An increase in inventory can hurt cash flow. This is typically the largest short-term asset of companies that sell products.
Low levels of depreciation – Any depreciation expenses that are recorded can decrease the book value of your long-term operating assets. Every year, your business will convert a portion of the total cost that has been invested in your fixed assets into cash and recoups it via the collection of cash from sales. If you don’t use depreciation, it can impact your cash flow.
Decrease in operating liabilities – A decrease in short-term liabilities can hurt cash flow, while an increase can do the opposite.
Is There Any Benefit To Liabilities?
Some liabilities can actually be a good thing for your business, particularly those that involve loans with a low-interest rate or even no interest at all. For instance, some of your business’s accounts payable may allow payment in a short period of time, such as 30 days. These types of payables are good to have to help keep cash in the bank until they’re due for full repayment. But too many liabilities can be a bad thing for business because they can place undue financial stress on your balance sheet.
Certain debts are needed to help grow your business. For instance, if you wish to expand your business – and therefore make it more profitable – you may require a loan to help cover the cost of a larger commercial space, more employees, marketing, or inventory. You can also use business loans to help build and establish your business credit score by making timely payments. This can help increase the odds that you will be able to secure future financing at reasonable rates and terms.
Liabilities are part and parcel of operating a business. But while some liabilities can be a good thing for business, others – especially in large amounts – can hurt your business’s cash flow. Be sure to understand the different types of liabilities that may be involved in your business and how they may impact your bottom line.