It doesn\u2019t take an accounting genius to say that you need income to be greater than expenses and that it\u2019s preferable to own more than you owe! But, sometimes, figuring out what makes up each category can be more complicated.<\/p>\n\n\n\n
Take liabilities for instance. As mentioned above, liabilities can be simply described as what you owe someone else<\/em>.<\/p>\n\n\n\n That \u201csomeone else\u201d could be your customers or clients, government agencies, or various lenders, vendors, or credit card companies. Sometimes liabilities are easy to identify, such as in the case of a bank loan or credit card balance. Sometimes, they are less obvious, such as when a client or customer purchases an annual subscription or service.<\/p>\n\n\n\n Yes, annual subscriptions are a liability.<\/p>\n\n\n\n Why? Because you owe them<\/em> a year of service. The revenue from a client\u2019s annual subscription should therefore be recorded as deferred or unearned revenue on the Balance Sheet and only recognized on the Income Statement as it is earned when the service is delivered. Since SaaS businesses frequently have annual subscription options, this is an important aspect not to overlook.<\/p>\n\n\n\n Generally speaking, liabilities can be grouped into two broad categories: current or short term liabilities and long-term liabilities.<\/p>\n\n\n\n Short term liabilities are obligations that must be fulfilled in one year or less. Long-term liabilities encompass everything else. It\u2019s fairly common for a business to have a higher quantity <\/em>of short term liabilities but a higher dollar value <\/em>of long-term liabilities. After all, one would expect the total amount owed over the next thirty years to be higher than that owed in the current year alone!<\/p>\n\n\n\n It\u2019s worth noting that \u201cone year\u201d doesn\u2019t mean \u201cwithin the calendar or fiscal year\u201d but an actual rolling twelve-month period from the date of reporting. Thus, the balance of some short term liabilities can remain fairly static for a significant amount of time. An example is the current portion of long-term debt: the amount due over the next twelve months for a single loan is unlikely to change much until the final year of the loan\u2019s term.<\/p>\n\n\n\n Also, since short term liabilities are obligations that must be fulfilled within one year or less, you may need to ensure that you have assets on hand to cover the liability in an emergency (i.e., having cash or equivalents on hand to pay off credit card debt or short-term loans). In some cases, a lender may stipulate that the loan is contingent upon a business maintaining above a certain Working Capital Ratio. Or the business\u2019s leaders (CFO, Controller, etc.) may set restrictions themselves to ensure they have enough working capital available.<\/p>\n\n\n\n So let’s take a look at what kind of accounts tend to fall under each of these categories.<\/p>\n\n\n\n In accounting, both liabilities and assets appear on the Balance Sheet as a snapshot of a moment in time. Unlike income and expenses, where you may want to look at them for a certain time period, assets and liabilities are viewed as of specific dates. Balance Sheet statements are frequently created at the end of a month, quarter, or year and thus, assets and liabilities are viewed as of those particular moments as well.<\/p>\n\n\n\n Assets are what you own and are owed – cash in the bank, accounts receivable, inventory, buildings, land, patents, prepaid subscriptions, etc. Interestingly enough, some of a business\u2019s assets are another party\u2019s liabilities.<\/p>\n\n\n\n Cash in the bank, or funds the bank owes you, is the bank\u2019s liability. <\/p>\n\n\n\n Money other people owe you is their liability, your assets.<\/p>\n\n\n\n Prepaid or annual subscriptions and memberships,or a service owed to you – their liability, your asset.<\/p>\n\n\n\n When trying to decide if something is an asset or a liability, it\u2019s worth taking the time to ask if it\u2019s something that is owed to you<\/em> – whether as a service or monetary compensation – or if it\u2019s something that you owe someone else<\/em>. This question can particularly help when considering accruals and deferrals or other less obvious items.<\/p>\n\n\n\n The capital ratio is a measurement that compares a business\u2019s assets to its liabilities to measure the liquidity of your business – and risk of doing business with you. By comparing assets and liabilities, anyone, internally or externally, can estimate a business\u2019s ability to meet its obligations.<\/p>\n\n\n\n So how does one calculate a capital ratio?<\/p>\n\n\n\n In accounting, the common capital ratio used is the Working Capital Ratio or Current Ratio which specifically measures the ability of a business to meet its obligations for the next year using only what it owns or is owed within that same time frame. <\/p>\n\n\n\n The formula:<\/p>\n\n\n\n <\/p>\n\n\n\n <\/p>\n\n\n\n So, if a business has $300,000 in Current Assets and $200,000 in Current Liabilities, their Working Capital Ratio would be 1.5:<\/p>\n\n\n\n $300,000 \/ $200,000=1.5<\/p>\n\n\n\n A Working Capital Ratio of 1.5-2.0 is generally considered a good one . A business theoretically has enough assets available in the next year to cover all of their liabilities in the same time period. <\/p>\n\n\n\n When the Working Capital Ratio drops below 1.0, the liquidity of the business is called into question and there may be doubts in their ability to continue to function (though the industry and age of the business will affect this). On the other hand, higher capital ratios may indicate that a business isn\u2019t making good use of its assets.<\/p>\n\n\n\n Liabilities generally cause some form of restriction on a business\u2019s operations. Many of these are simple and may not affect cash flow much, such as the obligation to provide access to software for a year, while others can be more severe, such as lender restrictions. <\/p>\n\n\n\n Nevertheless, they shouldn\u2019t be looked on in a purely negative light. Let’s take a look at some ways well-handled liabilities can assist a business\u2019s operations:<\/p>\n\n\n\nWhat are the main types of liabilities in financial accounting?<\/h2>\n\n\n\n
Short term liabilities<\/h3>\n\n\n\n
Long-term liabilities<\/h3>\n\n\n\n
What\u2019s the difference between liabilities and assets in accounting?<\/h2>\n\n\n\n
What\u2019s a capital ratio and how is it related to liabilities?<\/h2>\n\n\n\n
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<\/figure><\/div>\n\n\n\nHow do liabilities affect a business\u2019s current and long-term operations?<\/h2>\n\n\n\n