To run a business successfully, you need a clear grasp on your finances. While accounting software or an accountant can do much of the heavy lifting for you, you should still understand the key components of your finances. One of the most important elements to understand is your liabilities. Knowing what you owe and to whom is critical to running a profitable business.
What are liabilities in accounting?
Liabilities in accounting are the values of any money or other items that your business owes to a person or another business. In other words, liabilities are debts, whether they’re due in six days or six years. These include loans, unpaid invoices and other bills, employees’ wages, and any other debts that you need to pay off eventually.
In accounting, liabilities are distinct from assets because, while assets can include money that someone else owes your business (such as accounts receivable), liabilities are anything that you owe to someone else. When you deduct your business’s total liabilities from its assets, you’re left with the shareholder equity.
What role do liabilities play in business?
Liabilities are important in small business accounting because they represent claims that other businesses, people and even governments have against your assets. That’s why liabilities are offset against company assets on balance sheets to calculate shareholder equity, which essentially represents the net (book) worth of a company.
Liabilities are also significant in the context of a business’s ongoing operations. In the normal course of business, companies often take on debt to acquire inventory or assets, fund expansion projects, or even just pay overhead during times of low revenue.
Additionally, liabilities can have a real impact on a company’s bottom line. Many liabilities involve some sort of carrying cost – money that has to be paid regularly in the form of interest payments. Those payments are deducted – along with other costs – to calculate a business’s net profit.
What types of liabilities are there?
There are many different individual items that can represent liabilities for small businesses, including wages owed to employees, outstanding mortgages, vendor bills and unpaid taxes. However, all liabilities generally fall into one of two broad types based on when they need to be repaid: current (or short-term) liabilities and long-term liabilities.
- Current/short-term liabilities: These are debts that your business has to pay within a year. They can include short-term loans, tax bills, employee wages and vendor invoices.
- Long-term liabilities: Long-term debts are those that you don’t have to pay within the next 12 months. These usually include business term loans, lines of credit, pension liabilities or other deferred employee compensation.
A business can incur liabilities in many ways, and each has different long- and short-term impacts on your company’s finances. So, beyond knowing what liabilities are and which ones you have, it’s important to know how each of them works to understand what impacts they can have on your cash flow from one month to the next.
Here are a few of the most common business liabilities, though not all of them are applicable for all small businesses:
- Business lines of credit: This is money borrowed on a revolving line to finance business operations or purchase assets. Payments are usually interest only during the draw period, after which the line must be repaid in a lump sum or converted to a term loan.
- Business term loan: These loans can include mortgages on commercial property and SBA loans that help finance operations. Loan payments are made regularly, with a portion of each payment going toward the balance of the loan and the remainder going toward the loan’s interest.
- Merchant cash advance: This is a type of loan where retailers borrow against their future sales. The lender keeps a portion of all the retailer’s credit card sales until the advance is repaid.
- Tax bills: Depending on the business type and industry, these can include sales tax, payroll tax, and federal and state income tax.
- Vendor invoices: This includes any money you owe to attorneys, accountants, suppliers or independent contractors. All of these outstanding payments are technically a liability for your business.
- Wages: Liabilities include any money you owe to workers under employment contracts or for work they already performed.
- Employee pensions: Not many small businesses have pensions to worry about, but these can also include any short-term liabilities for 401(k) matching programs.
- Healthcare benefit plans: This is also more common for larger companies, but any long-term healthcare costs for employees who are owed these benefits also represent liabilities for a business. A good example of this might be retired employees who are still able to receive healthcare benefits.
How to calculate liabilities
You can calculate your business’s liabilities a couple of different ways, but the most common way is to simply add up the total amount you owe on all existing short- or long-term debts.
To do this, you first need to calculate the total amount owed for each of your business’s specific liabilities. You can do this by taking the initial balance and subtracting the total amount paid to date. The best small business accounting software can probably do this automatically when you enter loan amounts and payment schedules for any outstanding debts.
Initial Balance – Total Paid to Date = Remaining Liability
To calculate your business’s total liabilities, you simply repeat this process for each of your outstanding liabilities, then total up all the remaining balances (this is another typical feature of accounting software).
Another way to calculate liabilities is to take the total value of your company’s assets and subtract shareholder equity (the net value of the business). This leaves you with the total value of the business’s debt (liabilities).
Of course, this process is usually done in reverse, with shareholder equity being calculated by subtracting liabilities from total assets, but calculating liabilities this way is technically possible using accounting principles.
Total Assets – Shareholder Equity = Total Liabilities
Why calculate business liabilities?
Calculating liabilities on a regular basis is important for any small business owner because it helps you track how much money you owe. Liabilities almost always involve some level of ongoing cost, so tracking the total amount you owe helps you measure the burden of your liabilities on your cash flow.
Additionally, calculating liabilities is a key step in tracking the net value of a business over time. Failure to calculate your liabilities and other accounting mistakes can keep you from knowing the value of your business or if it’s even profitable.
Liabilities vs. Expenses
A business often incurs liabilities because it borrows money to pay for assets or some aspect of its operations – in other words, to pay for expenses. Examples would be borrowing money to pay for inventory or to renovate an office. Since this money has to be paid back to the lender at some point, the business must account for it as a future cash outlay. Even in the meantime, those liabilities also represent actual expenses for the business, as it makes regular payments (normally with interest) against the outstanding balances.
FYI: Put simply, liabilities are your debt, while expenses are the costs you took on the debt to pay for.
Of course, some liabilities are expenses that you just haven’t paid yet. Items such as vendor invoices, tax liability and owed wages fall into this category. These liabilities may simply represent short-term claims against a company’s assets – money that accounting records are indicating will be outlaid soon (even within the next 30 days), so it is excluded from a company’s net value (shareholder equity).
However, it’s still important to be mindful of incurring expenses that you won’t or can’t pay back right away. These will build your liabilities over time, reducing the total value of your business.