Although debt is something that people try to avoid, it is part and parcel of the business process. Every business has debts that are recorded in the books, which the accountants call “liabilities.”
As the owner of a small, creative-oriented business, you need to be aware of the concept of liabilities. Here, we cover the various aspects of liabilities to better understand your business's accounting side.
Liabilities are nothing but payments due to those you owe money to. These debts could be mortgages, pending bills, bank loans, or any amounts of money that you owe to people or organizations.
After a long career as an art dealer, Amrish Chauhan opened an art gallery in New York City in his early fifties. The gallery was a hit from the very start, but Amrish’s accounts were in a mess. Not being from an accounting background, he felt trapped.
When the art gallery entered into its second year, Amrish hired the services of a bookkeeping service. The first thing the accountant did was to make a list of his liabilities and shared the figures with Amrish.
He was shocked when he saw the total amount of liabilities. But the accountant had a good laugh and went on to share the details of the art gallery’s profits, which looked very respectable. Amrish was relieved and happily continued to run his gallery.
Having a successful business doesn’t mean that you have expert bookkeeping skills. Enlist personal expert support from a competent bookkeeping service like Fincent to see to the accounts side while you focus on what you know best about your business.
The liabilities of your business can be found on the balance sheet, a critical document maintained by the accountants. A balance sheet has three sections:
A balance sheet is not as scary or complicated as it may seem. It is usually a simple, single sheet of paper summarizing your company's assets, equity, and liabilities.
If Amrish or his accountants were to create a balance sheet, it would look like this:
Businesses will vary their way of recording the liabilities in their balance sheets. But generally, businesses divide liabilities into three heads, current liabilities, long-term liabilities, and contingent liabilities.
These are payments that are due within the next twelve months. These could be any number of outstanding payments, like bills, taxes, loans, or any payment for goods and services rendered by third parties.
Some examples of current liabilities are:
Also known as “non-current liabilities,” these are amounts that you need to pay over periods of more than twelve months.
They are separated from current liabilities because they simplify the process of seeing how liquid (capacity to pay off debts) a business is. Moreover, long-term liabilities fall under generally accepted accounting principles (GAAP).
Here are a few examples of long-term liabilities:
Although not all companies do it, many companies add a third category, contingent liabilities. These are potential liabilities – those that do not exist but could well appear in the future, for example, a lawsuit.
Another prime example of contingent liability is the warranty coverage for defective products supplied. If all goes well, these payments need not be made. But in a contingency, provisions may exist to cover the costs incurred.
What do you know about accured liabilities? Best example of it is when a business has incurred an expense but has not yet paid it out
Calculating liabilities is not that complicated – you need to record all your liabilities carefully and add them up in your balance sheet.
But keeping track of your liabilities goes deeper than just producing your balance sheet every month. There are other calculations, which you can perform to analyze and project how best to use your cash. These calculations are “credit accounting.”
Here are a few of the normal liability calculations commonly used for accountants in credit accounting:
This is the single most important equation that you are likely to come across in credit accounting. This calculation involves comparing the total liabilities with the total assets. It is an indicator of the health of the business.
The result is multiplied by 100 to express it in a percentage. The formula goes like this:
Debt Ratio = (Total Liabilities ÷ Total Assets) X 100
If we take the example of the balance sheet of Amrish’s art gallery:
Debt Ratio = ($265,000 ÷ $16,20,000) X 100 = 16.36%
A lower debt ratio indicates more capacity of a business to pay off its debts. Debt ratios differ widely from one business to another. However, a generalization is that if you have a debt ratio of 40% or less, you are in the clear.
A company with a debt ratio of 60% or more will negatively impact lenders and investors. With a debt ratio of 16.36%, Amrish’s art gallery was doing very well indeed!
The long-term debt ratio is a concept similar to the short-term debt ratio. The only difference is that current liabilities are not included in the equation.
Here’s the formula to calculate the long-term debt ratio:
Long-Term Debt Ratio = (Long Term Liabilities ÷ Total Assets) X 100
If a company has $100,000 in long-term liabilities with total assets of $500,000, the long-term debt ratio of that company would be:
Long-Term Debt Ratio = ($100,000 ÷ $500,000) X 100 = 20%
The long-term debt ratio helps to project the long-term liabilities of a business. Whatever number you start with, for healthy growth, the number should gradually decrease. If it increases, the business is increasingly relying on debts to grow.
The debt-to-capital ratio is another useful indicator that can provide a better insight into the health of a business. The formula for debt to capital ratio is:
Debt-to-Capital Ratio = ((Total Liabilities ÷ (Total Liabilities + Total Equity)) X 100
Coming back to Amrish’s art gallery, the calculation would go like this:
Debt-to-Capital Ratio = (($265,000 ÷ ($265,000 + $225,000)) X 100 = 54.1%
It is common for lenders to compare the debt to capital ratio of different companies to identify those with the least investment risk. As you can see with Amrish’s art gallery, due to a lower level of equities, the debt-to-capital ratio is rather high.
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