Financial Liabilities for businesses are like credit cards for an individual. They are handy because the company can employ "others' money" to finance its business-related activities for some period, which lasts only when the liability becomes due. However, one should be mindful that excessive financial liabilities can put a dent in the balance sheet and take the company to bankruptcy.
Net financial liabilities 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 are obligations or debts owed by an entity to external parties, often involving the repayment of funds or providing goods or services in the future. They include loans, bonds, accounts payable, and other contractual obligations that result in a future cash outflow.
Any future sacrifices of economic benefits that an entity must 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.
Other financial liabilities may usually be legally enforceable due to an agreement between two entities. But they are not always necessarily legally enforceable.
Financial liabilities 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 listed on the entity's balance sheet.
There is no single method for analyzing financial liabilities. However, finding meaningful ratios and comparing them with other companies is one well-established and recommended method to decide over investing in a company. There are specific traditionally defined ratios for this purpose. But you can very well come up with your ratios depending the purpose of the analysis.
Liabilities are classified into two types based upon the 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 and long-term liabilities. Let us understand the different types of other financial liabilities through the detailed explanation below.
For most companies, the long-term liabilities comprise mostly the long-term debt, which is often payable over periods longer than a decade. However, the other items classified as long-term liabilities include debentures, loans, deferred tax liabilities, and pension obligations.
On the other hand, so many items other than interest and the current portion of long-term debt can be written under short-term liabilities. Other short-term liabilities include payroll and accounts payable, which include money owed to vendors, monthly utilities, and similar expenses.
If 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 whether the refinancing process has begun. If yes, and if the refinanced short-term liabilities (debt in general) are going to become due over some time longer than 12 months due to refinancing, they can very well be reclassified as long-term liabilities.
Hence, only one criterion forms the basis of this classification: the next one-year or 12-month period.
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, financial liabilities must not be viewed in isolation when analyzing them. It is essential 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 net financial liabilities impact are the investors and equity research analysts involved in purchasing, selling, and advising on the shares and bonds of a company. They have to determine 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 to invest in them. To quickly size up businesses in this regard, traders have developed several ratios that help them separate healthy borrowers from those drowning in debt.
All items under net financial liabilities are similar to debt, which must be paid to the creditors in the future. 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. Therefore, wherever a ratio has a term called 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:
The debt ratio compares 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
So a clearer picture of the debt position can be seen by modifying this ratio to the "long-term debt to assets 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 specifically compares a company's long-term debt and the total capitalization (i.e., long-term debt liabilities plus shareholders' equity).
Capitalization ratio = Long term debt/(Long term debt +Shareholder's equity)
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.
Cash flow to debt ratio = Operating cash flow/total debt.
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 company earnings before interest and taxes (EBIT) ratio to the company's interest expenses for the same period.
The current and quick ratios are significant among other ratios used to analyze the short-term liabilities. Both help an analyst determine whether a company can 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 quick ratio is the ratio of the total current assets and fewer inventories to the current liabilities.
Quick ratio= (Total current assets-Inventories)/Total current liabilities
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.
Now that we understand the basics of other financial liabilities and its intricacies, let us apply the theoretical knowledge into practical application through the examples below.
These days, the whole oil exploration and production industry suffers from an unprecedented piling up of debt. Exxon, Shell, BP, and Chevron have combined debts of $ 184 billion amid a two-year slump. The reason is that crude oil prices have remained lower than profitable levels for too long. And these companies did not expect this downturn to extend this long. So they took too much debt to finance their new projects and operations.
But now, since the new projects have not turned profitable, they cannot generate enough income or cash to pay back that debt. Their income coverage ratios and Cash flow to debt ratios have seriously declined, making them unfavorable to invest in.
As the investment becomes unfavorable, investors pull out their money from the stock. As a result, the debt-to-equity ratio increases, as can be seen in the case of Exxon Mobil in the above chart.
Oil companies are now trying to generate cash by selling some of their assets every quarter. If they have enough assets, they can get enough cash by selling them off and paying the debt as it comes due. So, their debt-paying ability presently depends upon their Debt ratio.
On the other hand, companies like Pan American Silver (a silver miner) are low on debt. Pan American had a debt of only $ 59 million compared to the cash, cash equivalents, and short-term investments of $ 204 million at the end of the June quarter of 2016. The ratio of debt to cash, cash equivalents, and short-term investments is just 0.29. Cash, cash equivalents, and short-term investments are the most liquid assets of a company. And the total debt is only 0.29 times that. So, from the viewpoint of “ability to pay the debt,” Pan American is a very favorable investment compared to those oil companies.
Now, the above chart of Pan American also shows an increase in debt to equity ratio. But look at the value of that ratio in both charts. It’s 0.261 for Exxon and only 0.040 for Pan American. This comparison shows that investing in Pan American is much less risky than investing in Exxon.
Although liabilities are necessarily future obligations, they are a vital aspect of a company's operations because they are used to finance operations and pay for significant expansions. Let us understand the importance of net financial liabilities through the points below.
In essence, financial liabilities are specifically tied to monetary commitments, while non-financial liabilities involve a broader range of responsibilities that extend beyond immediate financial transactions.
Financial liabilities and non-financial liabilities are two distinct categories of obligations or debts that an entity might have. Let us understand the differences between the two through the comparison below.
to Financial Liabilities definition. Here we explain its types, ratios, and examples, and compare it with non-financial liabilities. You can learn more about finance through the articles below:
