Over the past 2 months, we have written articles to explain the components of a balance sheet which shows the extent of entity ownership of assets, liability and equity at a given point in time; a net worth statement for a company.
Today we focus on Liabilities. Liabilities are amounts of money you owe to creditors in the form of bills that are due, bank loans you have taken out, and bonds or warrants that you may have issued to raise money.
Like Assets, Liabilities are broken down into two classifications;
- Current Liabilities
- Long-term Liabilities
Current liabilities represent short-term debts that you have to repay within one year. Long-term Liabilities, on the other hand, are liabilities that require payment beyond a company’s operating cycle (i.e. longer than one year).
Let’s look at both classification of liabilities and examine examples of each.
As mentioned above, current liabilities are items a company owes that must be paid within one year. Examples of current liabilities would include; accounts payable, wages payable, property taxes payable, insurance payable, interest payable, notes payable, taxes payable, utilities payable, short-term loan payable and so on.
The Bakery’s Current Liabilities on its Balance Sheet as of December 31, 2012 are as follows;
|Accrued expenses payable
|Short-Term Loan Payable||$ 4,971|
|Total Current Liabilities||$27,383|
Let’s look at each of The Bakery’s current liabilities; beginning with Accounts Payable.
An account payable is a short-term liability a company incurs when it purchases items on credit. Furthermore, many businesses buy inventory, bakery supplies, bakery equipment, raw materials, wholesale goods etc. and elect to pay for them at a later date. As of December 31, 2012, the bakery still owes $14,524 for bakery supplies, equipment, inventory, and so on. As the bakery pays for these items, the account balance ($14,524) will decrease. Also, when the bakery purchases more items on credit, the accounts payable increases.
Accounts payable are considered current liabilities because payment is usually due in less than one year. Further, a company offering credit will usually request payment within 30, 60, or 90 days from the date of payment.
Accrued expenses payable
In addition to outside accounts payable, your business continuously accrues liabilities related to salaries or wages (if you have employees), insurance premiums, interest on bank loans, and taxes you owe. Any obligations that are unpaid at the time you run your balance sheet get grouped together in this category.
Income tax payable will always be considered a current liability since payment is due in less than one year. The Bakery will most likely pay the $7,888 tax obligation before April 30, 2013. Depending on where you live, laws are in place that requires businesses to pay income tax on an instalment basis.
Short-Term Loan Payable
Short-term loans that require payment in less than one year are classified into an account called Short-Term Loan Payable.
For example, on 10 July, 2012, The Bakery received a $7,000 short-term loan (1 year) from a local bank. The loan is considered a current liability because it’s due in less than one year. The Bakery is required to make monthly payments on the loan until it’s fully paid on 30 June , 2013. As of December 31, 2012 the outstanding balance owed on the loan is $4,971 (see balance sheet above). This means that from July to December, 2012, the company paid $2,029 on the loan ($7,000 – $4,971).
Why are Current Liabilities important?
They can tell us a lot about the current situation of a business but as stand-alone entries, they tell us little about the long-term nature of the business and whether or not it has durable competitive advantage. With this note we shall conclude today’s article and we hope you look forward to the out next article on Long-Term Liabilities.
Mind Kinesis Value Investing Academy