What is liability and how does it work in business?

You may have heard the phrase ‘XYZ is a limited liability company’ or noticed ‘LLC’ after a company’s name. If you’re starting a business or trading stocks, it’s essential to understand what liability is and how it affects businesses.
What is liability?
For traders, understanding liabilities is vital for assessing a company’s financial health, as they represent claims against assets.
Liabilities appear on a company’s balance sheet, usually on the right-hand side, opposite assets. They are recorded according to strict accounting principles and categorised by due date:
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Current liabilities – due within one year or operating cycle
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Non-current liabilities – due after more than one year
By examining liabilities, you can gauge a business’s debt levels, solvency, and ability to meet obligations.
Types of liability
When it comes to the types of liability, current and non-current liabilities are the main categories, depending on their maturity period.
Current liabilities
Short-term obligations due within one year (or one operating cycle). Examples include:
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Accounts payable (suppliers)
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Short-term loans
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Accrued expenses (eg, wages, utilities)
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Current portion of long-term debt
Non-current liabilities
Long-term obligations not due within one year. Examples include:
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Bonds payable
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Long-term loans
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Deferred tax liabilities
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Lease obligations
Legal liabilities
Beyond finances, companies may face legal liabilities arising from contracts, torts, or regulations. Examples include product liability, environmental claims, or lawsuits.
Liability vs. assets: key differences
Liabilities and assets are two fundamental components of a company's balance sheet, representing the opposite aspects of its financial position.
Assets
These are economic resources owned and controlled by the company. They are expected to provide future economic benefits. These can be tangible (like property, factory, machines, computers, etc.) or intangible (like patents, trademarks and goodwill).
Liabilities
Liabilities are what a business owes or the company’s commitment to transfer money to other entities in the future.
The relationship between assets and liabilities is expressed in this very common accounting equation:
This equation highlights that a company's assets are financed either by the owners' investment (equity) or liabilities (borrowed funds or using raw materials or office space before the due date of payment).
Understanding this distinction is important for financial analysis because it helps determine a company's financial flexibility. High levels of liabilities relative to assets indicate higher financial risk, while a strong asset base suggests greater financial stability.
Financial analysis helps you make trading decisions. Open a live account with Capital.com to begin trading stocks.
Understanding unlimited and limited liability in business
What happens when a business is unable to meet its liabilities? Are the business owners or shareholders responsible for meeting the financial obligations of their company? The extent to which business owners are personally responsible for the company's debts and obligations is determined by unlimited or limited liability.
Unlimited liability
What does unlimited liability mean in a business? Essentially, it means the owner's personal assets are not legally separate from the business's assets. So if the business incurs debts or faces legal claims, the owner's personal assets, such as their house, car, and savings, can be used to settle those obligations. This structure typically applies to sole proprietorships and general partnerships. For example, if a sole proprietor's business goes bankrupt, creditors can pursue the owner's personal assets to recover their money.
Limited liability
Protects owners’ personal assets. They are only liable up to the amount they invested. Corporations, LLCs, and LLPs fall into this category. If the company fails, only business assets are at risk.
Examples:
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Virgin Atlantic Limited
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Hertz Vehicles LLC
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Smith & Associates LLP
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Microsoft Corp
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Apple Inc
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SAP SE (Europe), Robert Bosch GmbH (Germany), Ericsson AB (Sweden), Kering SA (France)
The extension varies by country, but all indicate a limited liability structure.
How liabilities affect trading and investments
Learning about liabilities helps traders and investors assess a company’s financial health and prospects.
For long-term investors, liabilities are key in determining a company's overall financial stability and risk. High levels of long-term debt can increase a company's financial leverage, meaning a small change in earnings can have a large impact on shareholder returns. This can negatively affect the share price.
Instead of trying to evaluate all assets and liabilities, you can look at the debt-to-equity (D/E) ratio. This is among the most common ratios used in financial assessment and risk management. It shows the proportion of debt financing versus equity financing. A high D/E ratio suggests that a company relies heavily on debt to finance its operations, meaning higher financial risk. A low D/E ratio suggests lower financial risk.
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