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Tuesday, February 20, 2024

What is financial liability?

What is financial liability?

In the financial industry, financial liability is defined as a sum of money that one party or entity owes to another. In basic terms, it’s a debt that is owed at some point in the future. While some level of financial liability is essential, if your liabilities significantly exceed your revenue, it could jeopardize your financial stability. The same is true for personal and business finances. 

Understanding your financial liability can help you make smart money decisions in your life, both personally and professionally if you’re a business owner. 

How financial liability works 

Financial liability is a normal part of both business and personal finances. A liability occurs when a person or business receives assets or services, or the promise of future assets or services, but payment has not been made. This creates an obligation that must be paid at some point in the future. 

Current liabilities are those that require payment within the next 12 months, while noncurrent liabilities are those with longer repayment requirements. In accordance with Generally Accepted Accounting Principles (GAAP), most businesses must report both current and noncurrent liabilities on their balance sheets. On these balance sheets, liabilities plus owner’s equity equals assets. 

Types of financial liabilities 

Financial liabilities impact both personal and business finances. While both types of liabilities create an obligation to repay a debt, there are some differences between personal and business liabilities. 

Personal liability 

In personal finances, a liability is a debt you owe a lender, such as home mortgages, student loans, car loans and credit card debts. Some forms of liability can enable further financial goals. For instance, incurring student loans can be good if it allows an individual to maintain a high-paying career. Additionally, a home mortgage can be good because it allows a person to build equity. 

While some personal liability is to be expected, too much debt can be dangerous and impede a person's financial future. For example, if liabilities outweigh assets, there's a negative net worth. This negative value can hinder a person's ability to secure additional credit or save for retirement. More importantly, it may leave an individual unable to pay debts. 

It’s important to maintain a healthy net worth. Always double-check your budget and available funds before incurring more liabilities. This step can help prevent a negative net worth.   

Business liability 

Business liability is also a debt owed to another party. Typically, these liabilities include the exchange of assets or services that provide an economic benefit to the business. Business liabilities include both contractual obligations and contract settlements, such as equity settlements or derivative settlements. Some examples of business liabilities include accounts payable, mortgages, other loans and deferred revenues. 

Just as with personal liability, some level of business liability is expected. However, if this debt substantially exceeds company revenues, it will likely impact the continued success of the business. This factor is especially true if this debt continues to grow at a faster rate than company revenues for several years in a row. 

How to identify financial liabilities 

A financial liability is any money owed to another party. Common personal liabilities include home mortgages and student loans, while common business liabilities include accounts payable and deferred revenue. Liabilities can be short-term, such as credit card debt, or long-term, such as mortgages.   

Many businesses use financial liability reporting services to prepare their annual financial statements. These services follow GAAP standards and report most liabilities on the balance sheet portion of the financial statements. Some liabilities are nearly impossible to avoid. For example, if you want to purchase a home, you’ll likely need a home mortgage, which is a liability. For businesses, liabilities are also essential. For instance, businesses often purchase supplies and raw materials on credit, which is a liability. Or it might have to take out a loan to expand the business, which is another liability. 

Investors and lenders can use information from the company’s financial statements to assess its financial stability. In most cases, it’s better for companies to have a higher level of equity than liabilities. However, it’s even more important for the business to have enough revenue coming in to cover its debt responsibilities. 

Financial liabilities vs. assets 

While both assets and liabilities are reported on a company’s balance sheet, they're very different. Assets are something the company owns and can be classified as tangible or non-tangible. Tangible assets are those that you can touch, such as buildings and equipment. Intangible assets include accounts receivable and intellectual property rights. On balance sheets, assets are typically listed as current and noncurrent. 

On the other hand, liabilities are debt obligations the company owes, such as accounts payable and loans. On a balance sheet, the sum of all company assets must match the sum of all liabilities plus the owner’s equity: Assets = Liabilities + Owner’s Equity. 

Financial liabilities vs. expenses 

Expenses and liabilities may seem similar since they both involve the purchase of goods and services. However, these two financial terms are not the same and are treated differently on financial statements. 

An expense is money that's already paid for specific goods or services. Personal expenses include items such as rent, utilities and food costs. Expenses for businesses are costs involving activities of daily operations, such as the cost of labor, building maintenance and marketing. 

What is a financial liability, then? Rather than an expense, a liability is an obligation that the company must pay in the future. While these goods and services may play a role in daily operations, a company cannot list a liability as an expense until it’s paid for. 

Another difference between expenses and liabilities is how companies report them on their financial statements. Expenses are included on the company’s income statement, whereas liabilities are listed on the balance sheet. Companies use expenses to determine net income by subtracting these costs from revenue: Net Income = Revenue – Expenses. 

Companies report liabilities on their balance sheets to show the connection between assets and the sum of liabilities and owner’s equity. 

Factors affecting financial liability 

Since liability is a normal part of business activities, it can be difficult to determine if incurring this type of debt obligation is good or bad for the business. When assessing a company’s financial stability, the amount of liability it holds doesn’t tell the whole story. There are several other factors to take into account, such as: 

Level of income 

How much income the company is bringing in is extremely important when evaluating liability. A high level of liabilities may be of little to no concern if the company has enough revenue to cover these debts. Increased liabilities could be a sign of growth for the company, which in the long term could have positive results. If, however, the company’s revenues reported on the income statement are not enough to cover these debt obligations, especially in the short term, that could jeopardize the company’s future success. 

Credit history 

One of the biggest impacts of maintaining high liability levels is that it can hinder the company’s ability to secure future credit. Lenders may be leery to offer more credit to companies with excessive liabilities. This factor could impede the company’s ability to grow and remain competitive. If the company has a long and positive credit history, this may be enough to entice some lenders to offer credit despite a high liabilities. 

Current debts 

Current debts are liabilities that are due within the next 12 months. Investors and lenders often use the current ratio to evaluate the current financial health of the company. This ratio shows the relationship between current assets and current debts, and it shows the company’s ability to pay off its debt obligations for the upcoming year. For example, if a company has $1M in current assets and $500,000 in current debts, it would have a current ratio of 2:1. Companies should strive to have a current ratio of at least 1:1 to remain financially stable. 

Savings and investments 

When determining a company’s financial health, it’s also important to assess its savings and investment accounts. Both savings and investments are assets that are reported on a company’s balance sheet. Cash and liquid investments are especially important when evaluating liabilities because they can show the company’s ability to repay debt obligations in both the short and long term.   

What is unlimited financial liability? 

Unlimited financial liability means that the owner or partners of a business are legally responsible for all liabilities incurred by the company. If the company does well and can pay all its debt obligations, the owners and partners aren’t responsible for any of these bills. 

However, if at any point the company fails to meet its debt obligations or the business shuts down without paying off all debts, each owner and partner can be personally responsible for paying these debts. Collectors may have the right to sue the owners and partners in court and to possibly seize personal assets, such as the home, vehicles and bank accounts.   

Sole proprietorships and general partnerships often include unlimited financial liability. These types of business structures can put owners and partners at significant risk. There are both pros and cons to these business structures. 

Pros and cons of unlimited financial liability 

Pros: 

  • Business structure easier to set up 
  • Lets you maintain greater control over the company 
  • Offers a simplistic payment structure 
  • Has fewer financial disclosure requirements 

Cons: 

  • Owners and partners can be held legally and financially responsible for business debt 
  • Could make it harder to secure credit 

To avoid these issues, some business owners choose to form a limited liability corporation, or LLC, or a structured partnership. These business structures reduce the financial risk for owners and partners. 

The importance of proof of financial liability 

No matter what type of business you operate, maintaining financial liability insurance is crucial. This type of insurance can protect you and your company from both legal and financial implications if an incident, such as an accident or product malfunction, occurs. It’s also important to maintain financial liability insurance on your personal property, such as your home or vehicle, to protect your investment in the case of a fire, theft, accident or other incidents. 

There are several instances where you may be required to show proof of financial liability. First, if you’re in a car accident, you’re required to show proof of financial liability insurance. Secondly, when obtaining a loan to purchase a home, vehicle or equipment, the lender is likely to require proof of financial liability insurance prior to closing. 

Additionally, clients may require you to show proof of financial liability insurance before doing business with you. This is especially true for contractors who provide services for the customer. Finally, if you're facing legal proceedings, such as being sued by another party, you will likely need to provide proof of financial liability along with providing financial statements. 

There are several types of proof of financial liability, such as: 

  • Liability insurance policies 
  • Company financial statements 
  • Financial guarantees or bonds 

Insurance companies offer a variety of business liability packages. It’s important to explore your options to select the protection that is right for you or your business. 

Bottom line 

Liabilities are not necessarily a bad thing. In fact, some debt obligations are vital to reaching your personal and business financial goals. It's important not to overextend your liabilities to the point where you’re incurring a negative net worth and unable to meet these financial obligations. 

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The Currency editors

Staff contributors

The CurrencyTM, a publication from Empower, covers the latest financial news and views shaping how we live, work, and play. We keep you current on ways to plan, save, and invest for life.

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