Companies report their financial position on the balance sheet. The balance sheet presents a picture of the company’s assets, liabilities and owner’s equity balances as of a particular date. It normally takes a business several weeks to determine the account balances as of the closing date of the period. This time allows the company to identify and record any transactions not already included. Understanding the liabilities reported on the balance sheet provides several benefits to financial statement reviewers.
Liabilities represent any obligation the company owes to another entity. The balance sheet classifies liabilities into two categories, current liabilities and long term debt. Current liabilities refer to any money, product or service owed that the company needs to pay within one year. Examples of current liabilities include accounts payable. These accounts will be paid out of the company’s financial resources or by providing the agreed upon service. Long term debt refers to money owed whose repayment extends beyond one year. Examples of long term debt include bonds payable or notes payable.
The foundation of the balance sheet rests with the accounting equation. The accounting equation tallies up the account balances of the company’s financial records and ensures they balance. The assets must equal the liabilities plus the owner’s equity. Liabilities form an important segment of the balance sheet and the accounting equation because of the impact these accounts have on owner’s equity. The greater the total liabilities, the lower the owner’s equity.
Understanding Financial Obligations
Understanding the liabilities of the company allows financial statement reviewers to determine how well the company manages its debts. Too much debt means the company needs to make increasingly high debt payments to creditors. Long term debt communicates the company’s future debt payment obligations.
Calculating Financial Ratios
Several financial ratios exist that consider the impact of the liabilities. The current ratio subtracts the current liabilities from the current assets. This ratio communicates the company’s position for meeting its current financial obligations. When the current ratio equals a number less than one, the company has fewer current assets available than it has obligations to meet. Higher numbers represent the company’s stronger ability to meet its obligations. The debt to equity ratio calculates the company’s ability to meet its financial needs by borrowing money or by seeking investments. Strong companies balance financial needs between these two methods of financing, rather than relying heavily on one method or the other.