Importance of Liabilities & Their Impact On Business
Although liabilities are essentially future obligations, they are nonetheless a vital aspect of a company’s operations because they are used to finance operations and pay for large expansions.
Types of Financial Liabilities
Liabilities are classified into two types based upon the time 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 Liabilities and Long term Liabilities.
Short Term Liabilities
Long Term Liabilities
Long Term and Short Term Liabilities
For most companies, the long term liabilities comprise of mostly the long term debt which is often payable over periods even longer than a decade. However, the other items that can be classifies as long term liabilities include debentures, loans, deferred tax liabilities and pension obligations.
On the other hand, there are so many items other than interest and the current portion of long term debt that can be written under short term liabilities. Other short-term liabilities include payroll expenses and accounts payable, which includes money owed to vendors, monthly utilities and similar expenses.
In case a company has a short term liability which 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 also whether the process of refinancing has begun. If yes, and if the refinanced short term liabilities (debt in general) are going to become due over a period of time longer than 12 months due to refinancing, they can very well be reclassified as long term liabilities.
Analysis of Financial Liabilities
What is the need to analyse the liabilities of a company?
And who are the people most affected by a company’s liabilities?
Well, liabilities after all result into a pay out of cash or any other asset in the future. So, by itself a liability must always be looked upon as unfavourable. Still, when analysing financial liabilities, they must not be viewed in isolation. It is important to realise 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 financial liabilities impact are the investors and equity research analystswho are involved in business of purchasing, selling and advising on the shares and bonds of a company. It is they who have to make out how much value a company can create for them in 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 for the purpose of investing in them. As a way to quickly size up businesses in this regard, traders have developed a number of ratios that help them in separating the healthy borrowers from those who are drowning in debt.
Financial Liabilities Ratios
All the liabilities are similar to debt which needs to be paid in future to the creditors. 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. So wherever a ratio has a term by the name of debt, it would mean liabilities.
You can also learn step by step financial statement analysis here
The following ratios are used to analyse the financial liabilities:
1 – Debt Ratio
The debt ratio gives a comparison of 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 the “long-term debt to assets ratio”.
2 – Debt to Equity Ratio:
This ratio also gives an idea about 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
3 – Capitalization Ratio :
This ratio specifically compares the long term debt and the total capitalization (i.e. long term debt liabilities plus shareholders’ equity) of a company.
Capitalization ratio = Long term debt/(Long term debt +Shareholder’s equity)
4 – Cash Flow to Total Debt Ratio
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 of time.
Cash flow to debt ratio = Operating cash flow/Total debt
5 – Interest Coverage Ratio:
Interest coverage ratio gives an idea about the ability of a company to pay its debt by using its operating income. It is the ratio of a company’s earnings before interest and taxes (EBIT) to the company’s interest expenses for the same period.
Interest coverage ratio = EBIT/Interest expense
6 – Current Ratio and Quick Ratios
Important among other ratios used to analyse the short term liabilities are the current ratio and the quick ratio. Both of them help an analyst in determining whether a company has the ability to 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 less 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 analyse a company’s liabilities. However, there is no limit to the number and type of ratios to be used.
Financial Liabilities Example:
High Debt Companies:
These days, the whole oil exploration and production industry is suffering from an unprecedented piling up of debt. Exxon, Shell, BP and Chevron have combined debts of $ 184 billion amid two-year slump. The reason is that crude oil prices have stayed lower than profitable levels for too long now. And these companies did not expect this downturn to extend this long. So they took too much of debt in order to finance their new projects and operations.
But now, since the new projects have not turned profitable, they are unable to generate enough income or cash to pay back that debt. This means that their Income coverage ratios and Cash flow to debt ratios have seriously declined making them unfavorable to invest.
Exxon Mobil Debt To Equity (Quarterly Chart)
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.
Now, the oil companies are trying to generate cash by selling some of their assets every quarter. So, their debt paying ability presently depends upon their Debt ratio. If they have got enough assets, they can get enough cash by selling them off and pay the debt as it comes due.
Low Debt Companies
On the other hand, there are companies like Pan American Silver (a silver miner), which 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. This means that 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 of that. So, from a view point of “ability to pay the debt”, Pan American is a very favorable investment as compared to those oil companies at the moment.
Pan America Silver Debt To Equity (Quarterly)
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 while it’s only 0.040 for Pan American. This comparison clearly shows that investing in Pan American is much less risky than investing in Exxon.
There is no single method for analyzing financial liabilities. However, finding out meaningful ratios and comparing them with other companies is one well established and recommended method for the purpose of deciding over investing in a company. There are certain traditionally defined ratios for this purpose. But you can very well come up with your own ratios depending upon the purpose of analysis.