Starting a new business can be one of the most complex and challenging tasks, especially if you are a new entrepreneur.
A lot of effort, planning, and effective execution goes into just preparing a blueprint for a business idea to make it bankable and lucrative. Any entrepreneur’s goal is to add more profitable assets to her/his business while realizing its goals and fulfilling its liabilities.
And to work on the assets and liabilities, these concepts must be crystal clear to you to have productive outcomes. So, let’s find out the liabilities that you need to focus on as a business owner and what all constitute assets for you.
What Are Business Liabilities?
A liability is defined as the state of being legally responsible for something (OED) and is synonymously used for accountability and onus in the world of business. As a business owner, you have many responsibilities that need to be fulfilled and extremely time-bound. For instance, an entire business liability can be the repayment of any form of debt. Business liabilities are the volumes of money owed by a business at a given point in time. That is why they are also referred to as “payables” for accounting purposes in the balance sheets (possible interlink) of a company’s books.
Essential things to learn here are- how business liabilities arise and impact a business, the types of liabilities, and their analysis.
Assets and Liabilities
Whatever be the model, every business has assets and liabilities. Simply put, assets are the properties owned by a person or company, which are valuable enough and available at demand to meet debts and commitments, and liabilities are a company’s commitments and obligations-either in the form of owed money or services not yet performed.
Assets are, therefore, the items that benefit your company financially and help in growing the business. Inventory, infrastructure, equipment- all are a part of your company’s assets. Your business must have more assets than liabilities so that these assets can be converted into cash for growth or in case of an emergency. If the liabilities of a small business exceed its assets, it will not fulfil the company’s demands like debt repayment and will face other financial problems as well.
But liabilities are not necessarily counterproductive. They can play a significant role in generating capital for your business’s growth. For instance, a small business can take a loan for creating its assets like tools and inventories. These tools will further help the company grow, and the loan can be repaid once the business starts to post profits. This is how a liability, in this case, a loan, is turned to grow a company and its assets.
As new business owners, a lot of people often confuse liabilities with the expenses of their business. But there is more to both the terms than what meets the eye.
Business liabilities can play a significant role in generating capital for your business's growth.
Liabilities and Expenses: What is the difference?
Liabilities and expenses can be understood as responsibilities and costs. Business liability is the money owed by your company to another party. For example, if you buy a car for official use on a bank loan, this will become a business liability. On the other hand, an expense is a business operation in which costs are incurred in procuring goods that generate revenue for your company. For instance, when you buy office equipment like telephones and stationery, these will be counted towards your business expenses. The company will directly use them in growing the business and carrying out daily business growth activities.
Almost all the regular payments and costs incurred by a business are counted towards the company’s expenses. That is why the working capital of a company is meant for fulfilling its expenses. For example, when you pay for office services and utilities like rent or phone services, these are business expenses. If the payment of expenditures stops, the service will instantly.
Expenses and liabilities are shown in different places in the books of a company. Liabilities are charged to the bank account (balance sheets) related to the company’s assets, while expenses are put on the company’s income statement, i.e., profit or loss record.
Let us now understand the different types of business liabilities.
There are two main kinds of liabilities- those incurred in the short term and those induced in a long term.
Short-Term Business Liabilities
By definition, these liabilities are the business’s obligations that are expected to be paid off in the latest and fixed period, usually within a year. These are also called current liabilities.
Short term business liabilities usually include:
Sales Tax Dues: This amount is collected directly from the customer at the point of sale and is forwarded to concerned government revenue departments by a fixed due date.
Payroll Tax Dues: Employers collect this amount from employees. The collected amount is then paid to relevant tax agencies.
Loans and Mortgages Dues: This represents the repayments that may be required to pay-off within a year, including repayment of the instalments for a long-term loan.
Unearned Profits: This refers to the amount of money a company gets before offering their products and services. Mostly, this liability is incurred by businesses in the publishing and airline industry.
Long-Term Business Liabilities
These are the business liabilities and obligations whose repayment is expected to continue for a more extended period, usually for more than one year. These are also called non-current debts.
Long term business liabilities usually include:
Bonds Dues: These are the amounts to be paid by a company to a bondholder on a bond, or interest-bearing note, where the notice period is of more than one year.
Loans and Mortgages Dues: These are the elements of a loan or mortgage that need to be repaid after one year.
Leases: This includes parts of the lease payment, dues of which extend over one year.
You can read about GST to understand tax returns and dues filing.
Let us now understand How Business Liabilities Work.
When any item or product is bought in the name of a company, money is spent in the transaction, either directly or in the form of loans and credit lines. All the borrowed capital using which your company’s assets are amassed is categorized under the head of business liabilities. These liabilities have to be paid off at some point in time; unless paid off, creditors have a claim on your assets.
Some liability is suitable for a business from its leverage point of view, as borrowing initially helps in acquiring new assets, which, in turn, attracts and retains more customers and investors.
For example, suppose a food court has many customers but doesn’t have enough space to host the customers. In that case, the food court can borrow money in the form of loans to expand its premises and use the large footfall of customers as leverage while getting the loan approved. This way, the business will increase, and the loan’s liability, which will be paid off by the increased profits, will have proven to be beneficial in the long run.
Indeed, too many liabilities are not suitable for any business, be it a new business or an established business. Suppose most business income is spent on paying off debts for an extended period. In that case, enough money may not be left to cover even the business’s operating costs, leading to a business collapse.
Hence, it is essential to track and analyse your business liabilities.
Here is how you can Analyse Your Liabilities.
As a business owner, you can differentiate the amount of debt your company owes with other liquidity parameters, i.e., current ratio and debt-to-asset ratio, to determine if the company has too much liability.
This ratio helps determine if a company can pay its ‘short-term loans’ and fulfil the cash needs as per its current assets and liabilities.
To calculate the current ratio, total existing assets are divided by total current liabilities. If a rate of 2 comes as a result, it means that the business liabilities can be repaid with the current assets whereas a ratio below 2 indicates lower money holdings of the company and weaker repaying capability.
For example, if a firm has Rs 10,00,000 in total current assets and Rs 5,00,00 in total current liabilities, the company will quickly pay off the penalties as the current ratio comes out to be 2.
The debt-to-asset ratio is used to measure the total debt, both ‘long-term and short-term,’ regarding the whole business assets. It tells you if you have enough assets to sell to pay off your debt, in extreme cases.
A business’s debt-to-asset ratio should not be more than 0.3 to maintain its borrowing capacity and avoid being too highly leveraged.
For example, if a company has Rs 1,00,000 in total debt and Rs 3,60,000 in total assets, the debt-to-asset ratio of 0.27 is attained. As it is less than 0.3, the business will be able to repay the loans and finance some more assets to grow the business.
Proper management of finances and credit lines ensures the maintenance of liabilities and growth of business assets.
Therefore, it is clear that business liabilities are an integral part of any business and need to be correctly understood and analysed for sustainably running a business. Proper management of finances and credit lines ensures the maintenance of liabilities and growth of business assets.