Typically, before investing in the stock of a company, any investor would do their homework and research. The importance of this lies in knowing about the company you are investing in and whether it is worth investing in at all. After all, you may be investing your hard-earned cash intending to grow your capital, and making an informed decision helps you in the long run. This is where it is vital to know about a company’s assets and liabilities. Here, liabilities are touched upon in detail, but first, you must ask the question, “What is liability?”.
Understanding Liability
“What is liability?” may be a good question, to begin with when you are attempting to understand liabilities and how they affect companies and the stocks that companies generate. Broadly speaking, liability refers to something that a company or individual owes. What is owed is usually a sum of money. Liabilities may be settled over a period by transferring economic benefits including goods, money, or services.
Normally, when a company’s balance sheet, a financial statement of the company, is viewed, liabilities appear on the right side of the sheet. They typically include accounts payable, loans, deferred revenues, mortgages, bonds, accrued expenses, and warranties. You may contrast liabilities with assets to understand more details about liabilities.
Assets are things that individuals or companies own and which may garner economic benefits in the future. Liabilities reflect things that are borrowed or things that are owed. More about liabilities can be grasped if you know how they work.
How Liabilities Work
You now know what liabilities are, and how they contrast with assets. You even have a brief understanding of the types of liabilities. Before getting into the nitty gritty of types of liabilities, it is crucial to know how liabilities function.
Generally speaking, a liability represents an obligation between two parties which has not yet seen its end or has not yet been paid for. In the financial world, liabilities are in the form of some amount of money which has to be paid out. Although this may be a financial obligation, it is more defined based on prior business transactions, events, the exchange of assets/services, sales, or anything that would offer the economic benefit at a later time.
There are, broadly speaking, two main types of liabilities - current and noncurrent. Current liabilities are those that are considered short-term liabilities, that is, expected to be settled within a year or less time. Contrastingly, non-current liabilities need not be paid out in the short term. They may be settled after a year or more.
Types of Liabilities
You may have surmised by now that liabilities are obligations to be carried out by a company, and in terms of the stock of a company you may invest in, you may consider companies with as few liabilities as possible. Furthermore, even if a company has liabilities to fulfil, it should have enough assets to be able to settle liabilities in good time. This is why it is vital to know about the types of liabilities a company may have on its balance sheet. As mentioned earlier, any business may sort its liabilities into two main kinds - current/short-term and non-current/long-term. Here are the main types of liabilities, under current and noncurrent, explained in more detail:
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Current Liabilities
- Interest Payable
Like individuals, companies frequently use credit to buy products and services for financing purposes over short periods. This represents interest on the near-term credit purchases which have to be paid.
This is reflective of the total accrued income that employees have earned, but have not yet received.
If companies have issued shares to investors and pay dividends, this is a liability that represents any amount that is owed to shareholders following the declaration of the dividend.
This is an obligation on the part of a company to deliver goods and services after being paid for them in advance.
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Noncurrent/Long-Term Liabilities
- Bonds Payable
This is probably considered the biggest long-term liability of any given company and represents debt. Long-term debt, in the form of amounts the company owes other parties for loans taken on a long-term basis. Several companies, both large and small, issue bonds to finance certain ongoing long-term operations, like company expansions, for instance.
Some liabilities may have to be estimated. For instance, the estimated amount of money and time it takes to repair products according to a warranty comes under this kind of liability.
This is considered a broad category where liability is concerned. It may be evaluated as a current liability or a noncurrent one, based on specific transactions. Credits, in the simplest terms, reflect the revenue that is collected before it is noted as “earned” on the statement of income. What may be included among these types of liabilities could be client advances, or transactions in which credit may be owed (but not yet considered as revenue).
Invest with Information
Once you open a demat account to invest in the stock market, you may not just jump in and invest in companies without a second thought. If you are well-informed about a company’s liabilities, you can offset these against its assets and make decisions to invest or not to invest. Professionals consider that sensible ways to invest may include studying a company’s balance sheet in detail before investing in the company stock. Significantly, if you are considering any upcoming IPO, you may want to think of liabilities against the assets of a new company which is about to be listed.