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Grow Your Business Finances

Business Liabilities Every Owner Should Know

image for Jirapong_Manustrong / Getty Images
Jirapong_Manustrong / Getty Images
  • Liabilities are debts or other obligations your business owes money on, now or in the future.
  • Assets are items of value that your business owns, such as real estate and equipment.
  • Assets and liabilities are part of a business's balance sheet and are used to judge the business's financial health.
  • This article is for small business owners who want to learn about what liabilities are and see some examples of common business liabilities.

As a business owner, it's likely that you already have some liabilities related to your business. A liability is anything that your business owes money on or will owe money on in the future, and it is used in key ratios to determine your business's financial health. Read on to find out what liabilities, assets, and expenses are and how they differ from each other, as well as some examples of common liabilities for small businesses.

In the accounting world, assets, liabilities and equity make up the three major categories of a business's balance sheet. Assets and liabilities are used to evaluate the business's financial standing and to show the business's equity by subtracting the business's liabilities from the company's assets. For these reasons, it's important to have a good understanding of what business liabilities are and how they work.

Key takeaway: Liabilities, assets and equity are used to evaluate a business's financial health.

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Liabilities include everything a business owes, now and in the future. These can include loans, legal debts or other obligations that arise in the course of business operations, and they are often used to finance business operations, or pay for things like expansions or new equipment.

Liabilities can typically be found on the right side of a balance sheet. Most businesses have liabilities, unless they only accept cash payments and also pay with cash. There are three main types of liabilities:

  • Current liabilities: These need to be paid back within a year and include credit lines, loans, salaries, and accounts payable.
  • Long-term liabilities: These take more than a year to repay and include things like mortgages or bonds.
  • Contingent liabilities: These are liabilities that depend on the outcome of a future event, such as a lawsuit.

Current liabilities, also known as short-term liabilities, are generally watched closely by a business's management team to ensure that the business has enough liquidity – or ability to cover immediate and short-term obligations – to cover your outstanding debts. Examples of current liabilities include accounts payable, interest payable, income taxes payable, bills payable, short-term loans, bank account overdrafts and accrued expenses.

Current liabilities can be used as a key component to judge how the business is doing financially using the following key ratios:

  • Current ratio: Current assets divided by current liabilities
  • Quick ratio: Current assets minus inventory divided by current liabilities
  • Cash ratio: Cash and cash equivalents divided by current liabilities

Non-current liabilities can also be known as long-term liabilities, since they come due after more than a year's time. Businesses will take on a long-term liability to acquire immediate capital to purchase, for example, an office building or computer equipment, or to invest in new capital projects.

Long-term liabilities are vital for determining a business's long-term solvency, or ability to meet long-term financial obligations. Businesses can fall into a solvency crisis if they are unable to pay their long-term liabilities when they come due.

Contingent liabilities are also known as potential liabilities and only affect the company depending on the outcome of a specific future event. For example, if a company is facing a lawsuit, they face a liability if the lawsuit is successful but not if the lawsuit fails. For accounting purposes, a contingency liability is only recorded if a liability is probable and if the amount can be reasonably estimated.

Assets are everything a business owns, and these are typically found on the left side of a balance sheet. There are two types of assets:

  • Current assets: These are assets that can be converted into cash, such as accounts receivable and inventory.
  • Fixed assets: These are physical items that the business expects to own for more than a year and has financial value to the company, such as tools, vehicles or computer equipment.

An expense is the cost of operations that a company incurs to generate revenue. The major difference between expenses and liabilities is that an expense is related to a company's revenue. Expenses and revenue are listed on an income statement but not on a balance sheet with assets and liabilities.

Expenses can also be paid immediately with cash, while delaying payment would make the expense a liability.

Key takeaway: Liabilities are anything a business owes now or in the future and can be classified as current or non-current. Assets are anything of value a business owns and be current or fixed.

A simple way to understand business liabilities is to look at how you pay for anything for your business. You pay either with cash from a checking account or you borrow money. All borrowing creates a liability, including using a credit card to pay.

All of your liabilities will be shown on your balance sheet, which is a financial statement that shows how your business is doing at the end of an accounting period. Liabilities can be settled over time through the transfer of money, goods or services.  

To calculate your total liabilities, you can list all of your liabilities and add them together.

You can also use a basic accounting formula to find out if your books are balanced. To do this, calculate liabilities + equity = assets. To be balanced, your total liabilities plus your total equity must equal the number of total assets. [Read related article: Accounting Ratios and Formulas: The Basics You Need to Know]

Key takeaway: Business liabilities are accrued when you borrow money to pay for anything for your business and must be settled over time. To find out if your books are balanced, add your liabilities and your equity. If it's balanced, it will equal your total assets.

There are many types of business liabilities, both current and non-current. Here are some of the most common types.

Examples of current liabilities

  • Wages payable: This is the total amount of accrued income employees have earned but have not yet received. This liability changes often because most employees are paid every two weeks. 
  • Interest payable: Since companies use credit to purchase goods and services, this liability represents the interest on short-term credit purchases to be paid. 
  • Dividends payable: For companies that have issued stock to investors and pay dividends on those stocks, this current liability represents the amount owed to shareholders after the dividend was declared.

Examples of non-current liabilities

  • Deferred credits: These items may be recorded as current or non-current liabilities depending on the transaction, and are revenue collected prior to it being earned and recorded on an income statement. 
  • Post-employment benefits: These are benefits an employee or their family members may receive once that employee retires, which are carried as a long-term liability as it accrues. 
  • Unamortized investment tax credits: This liability represents the net between an asset's historical cost and the amount that has already been depreciated. 
  • Warranty liability: This is when there is an estimated amount of time and money that may be spent repairing something under the terms of a warranty.

Here's a sample balance sheet that shows the liabilities on the right and assets on the left, with the business's equity noted at the bottom.

 

Key takeaway: There are many types of current and non-current liabilities that most small businesses encounter over time.