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?

In business and finance, a liability is a company’s responsibility to pay an amount to another party. Many assume liabilities only come from business loans, but they can arise from many transactions. The common factor is that settling a liability usually involves an outflow of money.

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:

Current liabilities – due within one year or operating cycle
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:

Accounts payable (suppliers)
Short-term loans
Accrued expenses (eg, wages, utilities)
Current portion of long-term debt

Non-current liabilities

Long-term obligations not due within one year. Examples include:

Bonds payable
Long-term loans
Deferred tax liabilities
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:

Assets = liabilities + equity

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.

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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:

Virgin Atlantic Limited
Hertz Vehicles LLC
Smith & Associates LLP
Microsoft Corp
Apple Inc
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.

A company's liabilities indicate its short-term solvency and liquidity. The proportion of current liabilities to current assets shows whether a company can meet its immediate obligations. High levels of short-term debt can indicate potential cashflow problems. Checking this is very important for day trading.

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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FAQs

What are examples of liabilities in business?

Liabilities in business include accounts payable, salaries payable, short-term loans, long-term bank loans, bonds payable, deferred revenue (payments received for goods or services not yet delivered), and accrued expenses (like utility bills).

What is the difference between a liability and an expense?

A liability is an obligation to pay an amount in the future. It represents a claim against the company's assets. An expense is the cost incurred for generating revenue. While an expense might lead to a liability, an expense is typically consumed within an accounting period, whereas a liability represents an ongoing obligation.

How do liabilities impact a company’s stock price?

Liabilities influence investor perception of a company’s financial health and risk. High levels of debt signal higher financial risk, exerting pressure on the stock price. Manageable liabilities can boost investor confidence and support a higher stock price.

What is a good debt-to-equity ratio?

This varies significantly across industries. For example, more capital-intensive industries, like utilities, have higher acceptable D/E ratios.

How can traders use liability analysis to make better investment decisions?

Liability analysis indicates a company's short-term liquidity and long-term solvency. By examining current liabilities against current assets, traders can gauge a company's ability to meet immediate obligations. For long-term decisions, they look at debt levels and the debt-to-equity ratio to understand financial risk and leverage.