Do you know the liabilities definition? Most of us are familiar with liabilities from our Accounting 101 classes. One of the most popular formulas in that class was Assets = Liabilities + Shareholder’s Equity from the balance sheet. We covered assets in a different article. Now, it’s time to expand on the liabilities section of this financial statement. Some companies only have a $1,000 debt on a credit card. Meanwhile, most multinational public companies have much, much more than that. Let’s look at different kinds of debt owed by big companies and their different uses as we learn the definition of liabilities.
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Liabilities Definition Introduction
Let’s start off learning the definition of liabilities. Most liabilities are separated into short-term, short-term liabilities due in less than 12 months, and non-current, due in more than 12 months.
Liabilities can include debt, bonds, mortgages, accounts payable, etc. Further down, we will look deeper into those in more detail.
Companies in different stages of growth will have different debt vehicles. A startup will have much more debt than a market leader. Some public companies aren’t profitable even years after they become public.
Some popular examples are Airbnb (NASDAQ: ABNB), Uber (NYSE: UBER), and Lyft (NASDAQ: LYFT)—basically, the majority of LUPA stocks.
Why Do Companies Take Out Debt?
To make money, it takes money. However, borrowing becomes necessary when you don’t have enough or enough to start a successful business. Companies are private before taking the big leap into the stock market and becoming public.
If the business plan is solid and unique, it’s much easier and quicker to receive funding as a private company. Unfortunately, banks are often reluctant to loan money to unproven companies with little or no track record.
Private Placement
Enter private placements from venture capital companies, crowdfunding, or private investors. But, again, the terms and amounts can make a difference. So why do companies take out debt?
Salaries & Benefits: Unless the business is run only by the founders, it’s necessary to pay the employees. This can be in the form of a salary, stock benefits, or options. The pay structure has to be competitive to keep quality employees, and the business needs a solid plan. All this requires money.
Infrastructure and Equipment: Debt can also fund the purchase of various equipment and infrastructure necessary to run and grow the business.
Mergers & Acquisitions: M&As are a very widespread use of borrowed funds. They allow a company to grow in the same or complementary segment.
Research & Development: R&D allows companies to release new and improved products. Two recent examples are Pfizer (NYSE: PFE) and Moderna (NASDAQ: MRNA). They quickly began R&D to release a vaccine available in large quantities. The same can be applied to most industries.
Companies that efficiently allocate their borrowed funds are more likely to succeed than private or public companies. Conversely, those who use those funds to pay top management or give out bonuses are only there to get richer instead of investing in the business.
Before investing in a company, it’s important to look at its debt structure (types of liabilities) and its different uses for it.
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Types of Liabilities
Accounts Payable: This category is usually short-term debt. It includes wages, interest, dividends, income taxes, and what is due to the vendors.
Unearned Revenues: When a company receives payment for a service or goods delivered in advance, it is first counted as a liability. Once it is delivered, the amount will be offset.
Discontinued Operations: When an operation is no longer profitable, it can be discontinued. Examples can be the closing of a production facility or the discontinuation of a product. Growing companies are much more affected by this. In recent years, many cannabis companies opened too many facilities. They ended up being unsustainable, and they had to close down. As a result, the companies and their shareholders lost much money that could have been used more efficiently. Companies are required to disclose the financial impact of such operations.
Short-term Debt: Current debt is due in less than one year. This includes lines of credit and short-term loans.
Long-term Debt: Non-current debt is due in more than one year. This includes mortgages, bonds, and notes payable. The last two items are often two of the biggest components of the liabilities section.
Contingent Liabilities: This is reserved for events that may occur depending on future events.
Why do companies that have cash reserves take out loans instead? The answer is quite simple. Small collateral can be used to take out much bigger loans. As a result, it becomes easier to grow the company. Let’s take a look at a few companies.
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When Is there Too Much Debt?
Unfortunately here, the answer isn’t always straightforward with the liabilities definition.
Many factors come in place. One of the most important is a balance between short-term and long-term debt.
Too much debt due in less than 12 months is unsustainable. At the same time, too much long-term debt with high-interest rates is as well. There must be a balance between short-term, long-term debt, lines of credit and other debt instruments to have some diversification.
Yes, diversification isn’t only for investors. It is also very useful for companies and their debt structure. Thankfully, we can perform a fundamental analysis thanks to a few ratios. They allow us to compare companies in the same industry.
1. Current Ratio
First, the current ratio is obtained by dividing the current assets by the current liabilities. Quick reminder, current debt is due in less than 1 year. Current assets are very liquid. They can be transformed into cash almost immediately. This includes cash, accounts receivables, inventory and liquid investments.
It determines the capacity of paying current debt with current assets. A ratio below 1 indicates that a company can pay all its short-term debts with no issue.
On the other hand, a ratio above 1 indicates a potential risk. There may not be enough cash to pay its current debt.
2. Debt Ratio
Next, the debt ratio is derived by dividing total debt by total assets. In an ideal world, the number obtained is below 1. In that case, the company has more assets than debt. Unfortunately, it isn’t always the case. Newer companies usually have more debt than assets.
They’re still at the beginning of their lifecycle and need to finance operations as quickly as possible. This requires a lot of money.
Many other useful ratios exist. It can be useful to have a basic understanding of them to compare companies in the same field. Some stocks may be undervalued when we compare these ratios.
Final Thoughts: Liabilities Definition
To conclude the liabilities definition, they’re an important factor in a company’s success. Therefore, choosing the right mix of short-term and long-term liabilities is essential.
It’s also important to use the debt efficiently. Managing new companies often makes crucial mistakes when it’s time to allocate funds. Many ratios help investors choose between companies in the same industry.
They’re easy to compare and easy to understand. Making the right stock picks doesn’t only come to liabilities. There are a plethora of other factors to consider. We can help with our online courses, tools, and trading techniques. You can take a look over here.
