Financial Liabilities

 

Financial Liabilities | Definition, Types, Ratios, Examples

Financial Liabilities

Financial Liabilities for business are like credit cards for an individual. They are very useful in the sense that the company can use employ “others’ money” in order to finance its own business-related activities for some time period which lasts only when the liability becomes due. However, one should be mindful that excessive financial liabilities can put a dent on the balance sheet and can take the company on the verge of bankruptcy. 

Therefore it is important for financial analysts and investors to be aware of what they are and how they impact the company’s financial position.

We discuss the following Financial Liabilities in detail –

• What are Financial Liabilities?
• Importance of liabilities & their impact on business
• Types of financial liabilities
• Long term and Short term liabilities
• Analysis of Financial Liabilities
• Financial liabilities Ratios
  • #1 – Debt ratio
  • #2 – Debt to equity ratio
  • #3 – Capitalization ratio
  • #4 – Cash flow to total debt ratio
  • #5 – Interest coverage ratio
  • #6 – Current Ratio and Quick Ratio
• Conclusion

What are Financial Liabilities?

Any future sacrifices of economic benefits that an entity is required to make as a result of its past transactions or any other activity in the past. The future sacrifices to be made by the entity can be in the form of any money or service owed to the other party.

• Financial liabilities may be usually legally enforceable due to an agreement signed between two entities. But they are not always necessarily legally enforceable.
• They can be based on equitable obligations like a duty based on ethical or moral considerations or can also be binding on the entity as a result of a constructive obligation which means an obligation that is implied by a set of circumstances in a particular situation, as opposed to a contractually based obligation.
• Financial liabilities basically include debt payable and interest payable which is as a result of the use of others’ money in the past, accounts payable to other parties which are as a result of past purchases, rent and lease payable to the space owners which are as a result of the use of others’ property in the past and several taxes payable which are as a result of the business carried out in the past.
• Almost all of the financial liabilities can be found listed on the balance sheet of the entity.

Importance of liabilities & their impact on business

Although liabilities are essentially future obligations, they are nonetheless a vital aspect of a company’s operations because they are used to finance operations and pay for large expansions.

• Liabilities also make business transactions more efficient to carry out. For instance, if a company needs to pay for every little purchased quantity every time the material is delivered, it would require several repetitions of the payment process within a short period of time.
• On the other hand, if the company gets billed for all its purchases from a particular supplier over a month or a quarter, it would clear all the payments owed to the supplier in a very limited number of transactions.
• However, they all have a date of maturity, stated or implied, on which they come due. Once liabilities come due, they can be detrimental to the business.
• Defaulting or delaying the payment of liability may add more liabilities to the balance sheet in the form of fines, taxes and increased interest rates.
• Further, such acts can also damage the reputation of the company and affect the extent to which it will be able to use that “others’ money” in the future.

Types of financial liabilities

Liabilities are classified into two types based upon the time period within which they become due and are liable to be paid to the creditors. Based on this criterion the two types of liabilities are Short-term or Current Liabilities and Long term Liabilities.

Short term Liabilities

• short term or current liabilities are those that are payable within a period of 1 year (next 12 months) from the time the economic benefit is received by the company.
• In other words, the liabilities that belong to the current year are called short term liabilities or current liabilities.
• For example, if a company has to pay yearly rent by virtue of occupying a land or an office space etc. then that rent will be categorized under current or short term liabilities.
• Similarly, the interest payable and that part of long term debt which is payable within the current year will come under a short term or current liabilities.

Long term liabilities

• Long term liabilities are those that are payable over a period of time longer than 1 year.
• For example, if a business takes out a mortgage payable over a 15 year period, it will come under long term liabilities.
• Similarly, all the debt that is not required to be paid within the current year will also be categorized as a long term liability.

Long term and Short term liabilities

For most companies, the long term liabilities comprise mostly the long term debt which is often payable over periods even longer than a decade. However, the other items that can be classified as long term liabilities include debentures, loans, deferred tax liabilities, and pension obligations.

On the other hand, there are so many items other than interest and the current portion of long term debt that can be written under short term liabilities. Other short-term liabilities include payroll expenses and accounts payable, which includes money owed to vendors, monthly utilities and similar expenses.

In case a company has a short term liability that it intends to refinance, some confusion is likely to arise in your mind regarding its classification. To clear this confusion, it is required to identify whether there is any intent to refinance and also whether the process of refinancing has begun. If yes, and if the refinanced short term liabilities (debt in general) are going to become due over a period of time longer than 12 months due to refinancing, they can very well be reclassified as long term liabilities.

Hence, there is only one criterion that forms the basis of this classification: the next one year or 12 month period.

Analysis of Financial Liabilities

What is the need to analyze the liabilities of a company?

And who are the people most affected by a company’s liabilities?

Well, liabilities, after all, result in a payout of cash or any other asset in the future. So, by itself, a liability must always be looked upon as unfavorable. Still, when analyzing financial liabilities, they must not be viewed in isolation. It is important to realize the overall impact of an increase or decrease in liabilities and the signals that these variations in liabilities send out to all those who are concerned.

The people whom the financial liabilities impact are the investors and equity research analysts who are involved in the business of purchasing, selling and advising on the shares and bonds of a company. It is they who have to make out how much value a company can create for them in the future by looking at the financial statements.

For the above reasons, experienced investors take a good look at liabilities while analyzing the financial health of any company for the purpose of investing in them. As a way to quickly size up businesses in this regard, traders have developed a number of ratios that help them in separating the healthy borrowers from those who are drowning in debt.

Financial liabilities Ratios

All the liabilities are similar to debt which needs to be paid in the future to the creditors. For this reason, when doing the ratio analysis of the financial liabilities, we call them debt in general: long term debt and short term debt. So wherever a ratio has a term by the name of debt, it would mean liabilities.

You can also learn step by step financial statement analysis here

The following ratios are used to analyze the financial liabilities:

#1 – Debt Ratio

The debt ratio gives a comparison of a company’s total debt (long term plus short term) with its total assets.

Debt ratio Formula =Total debt/Total assets=Total liabilities/Total assets

• This ratio gives an idea of the company’s leverage i.e. the money borrowed from and/or owed to others.
• Sometimes analysts use it to gauge whether the company can pay out all its liabilities if it goes bankrupt and has to sell off all its assets.
• That’s the worst that can happen to a company. So if this ratio is greater than 1, it means that the company has more debt than the cash it can have on selling its assets.
• Hence, the lower the value of this ratio, the stronger the position of the company is. And thus, investing in such a company becomes as much less risky.
• However, generally the current portion of total liabilities i.e. the current liabilities (including the operational liabilities, such as accounts payable and taxes payable) is not as risky as they don’t need to be funded by selling off the assets.
• A company usually funds them through its current assets or cash.

So a clearer picture of the debt position can be seen by modifying this ratio the “long-term debt to assets ratio”.

#2 – Debt to equity ratio:

This ratio also gives an idea of the leverage of a company. It compares a company’s total liabilities to its total shareholders’ equity.

Debt to equity ratio = Total debt/Shareholder’s Equity

• This ratio gives an idea about how much its suppliers, lenders, and creditors are invested in the company compared to its shareholders.
• It also tells about the capital structure of the company. The lower this ratio is, the lesser the leverage and the stronger the position of the company’s equity.
• Again, you can analyze the long term debt against the equity by removing the current liabilities from the total liabilities. That’s the analyst’s choice as per what exactly he is trying to analyze.

#3 – Capitalization ratio:

This ratio specifically compares the long term debt and the total capitalization (i.e. long term debt liabilities plus shareholders’ equity) of a company.

Capitalization ratio = Long term debt/(Long term debt +Shareholder’s equity)

• This ratio is considered to be one of the more meaningful of the “debt” ratios – it delivers the key insight into a company’s use of leverage.
• If this ratio has a low value, it would mean that the company has a low long term debt and a high amount of equity.
• And it is well known that a low level of debt and a healthy proportion of equity in a company’s capital structure is an indication of financial fitness.
• Hence, a low value of capitalization is considered favourable by an investor.

#4 – Cash flow to total debt ratio:

This ratio gives an idea about a company’s ability to pay its total debt by comparing it with the cash flow generated by its operations during a given period of time.

Cash flow to debt ratio = Operating cash flow/Total debt

• The total debt does not completely belong to the given period since it also includes the long term debt.
• Still, this ratio indicates whether the cash being generated from operations would suffice to pay the debt in the long term.
• Unlike the above three ratios, the debt related number (Total debt) comes in the denominator here.
• So, the more the operating cash flow is, the greater this ratio is. Thus, a greater value of this ratio is to be considered more favourable.

#5 – Interest coverage ratio:

An interest coverage ratio gives an idea about the ability of a company to pay its debt by using its operating income. It is the ratio of a company’s earnings before interest and taxes (EBIT) to the company’s interest expenses for the same period.

Interest coverage ratio=EBIT/Interest expense

• A greater value of this ratio must be taken as favourable while a lower value must be considered as unfavourable for investment.
• This ratio is quite different from the above four ratios by virtue of being a short term liability related ratio.
• It takes into account only the interest expense which is essentially one of the short term liabilities.
• Also, do have a look at Debt Service coverage Ratio (important for credit analysts)

#6 – Current Ratios and Quick Ratios

Important among other ratios used to analyze the short term liabilities are the current ratio and the quick ratio. Both of them help an analyst in determining whether a company has the ability to pay off its current liabilities.

The current ratio is the ratio of total current assets to the total current liabilities.

Current ratio=Total current assets/Total current liabilities

The current ratio is a liquidity ratio that measures a company’s ability to pay short-term and long-term obligations.

The quick ratio is the ratio of the total current assets fewer inventories to the current liabilities.

Quick ratio= (Total current assets-Inventories)/Total current liabilities

• The quick ratio measures a company’s ability to meet its short-term obligations with its most liquid assets.

The above ratios are some of the most common ratios used to analyze a company’s liabilities. However, there is no limit to the number and type of ratios to be used.

• You can take any suitable terms and take their ratio as per the requirement of your analysis. The only aim of using the ratios is to get a quick idea about the components, magnitude, and quality of a company’s liabilities.
• Also, as is true with any kind of ratio analysis, the type of company and the industry norms must be kept in mind before concluding whether it is high or low on debt when using the above ratios as the basis. It is a comparative analysis after all!
• For instance, large and well-established companies can push the liability component of their balance sheet structure to higher percentages without getting into trouble while smaller firms may not.

Conclusion

There is no single method for analyzing financial liabilities. However, finding out meaningful ratios and comparing them with other companies is one well established and recommended method for the purpose of deciding over investing in a company. There are certain traditionally defined ratios for this purpose. But you can very well come up with your own ratios depending upon the purpose of analysis.