Yesterday, we talked about assets being something the company owns. We did a high-level overview of assets as a whole and then went into detail around the more common ones.
Today, we’re chatting about the other side of that coin: liabilities.
What You Owe
Liabilities are what the company owes. Current liabilities are due within one year and include accounts payable (amounts you owe for day-to-day operations), credit card balances, and the payments you’re required to make on long-term debt in the next year, if applicable. Long-term liabilities are due after one year, like a mortgage on a building, for example.
These are day-to-day payables that are required for the regular business your company conducts (although slightly different, accounts payable and trade payables are usually used interchangeably). Think of this is as the opposite of accounts receivable. The amount your business owes to another company is receivable for them. Likewise, the amount receivable to your company from another business is payable for them.
By calculating the average time your payables are outstanding, you can tell how long it takes for you to pay suppliers. How long you leave payables outstanding is a cash management decision. The longer you leave it, the longer you hold onto your cash to use for other things.
Let’s say your supplier offers 2/10 net 30 terms (that means a 2% discount if paid within 10 days, the entire balance due in 30 days). Can you make more than 2% on your cash in 30 days? If so, it’s probably worth it to wait until Day 30 to pay the bill because you’ll make more than the 2% you would’ve saved. If not, you could pay the balance in 10 days and save yourself 2%. Comparing options for payment timing is a basic concept of cash management.
Letting it go past the due date isn’t recommended. Even if the amount of interest you would pay is lower than what you could make on your free cash, your supplier won’t want to deal with you if you’re consistently paying them late.
Current Portion of Long-Term Debt
This is the amount a company is required to pay on any long-term debt within the year. Mortgage payments or car payments due within the year fall into this category. As the long-term debt becomes due, it’s moved from long-term liabilities into current liabilities and eventually moved off the balance sheet by being paid out.
Debt is usually compared to assets and equity to show the relationship between what’s owned and what’s owed. If a company owes much more than it owns, that’s a problem.
Comparing current liabilities to current assets (current assets/current liabilities) gives you a ratio that describes how easily the company can cover short-term debts with liquid assets. For example, if current liabilities are twice as much as current assets, the company will have difficulty being able to pay suppliers and make mortgage payments. If, on the other hand, current assets are twice as much as current liabilities, the company should have no problem paying bills and might be in a good position to invest in new equipment.
While none of us really like to owe money, sometimes it’s useful. As long as the money you borrow is making more than it costs to borrow, you’ll come out ahead. By not borrowing, you may be missing an opportunity. It will take longer to build and grow a business if you only use your own money.
Borrowing allows you to invest a large sum of money into your company to pay for things like new equipment with more capacity or faster production speed. An investment like that would allow you to grow the business, pay off the loan, and ultimately, improve your position.
Debt financing versus equity financing also allows you to retain control over the company because you haven’t sold a piece of the company to someone else, to whom you are now responsible. We’ll talk more about equity tomorrow.
Task: Look at the balance sheet from yesterday. What debts does the company have? Why do you have them? Or maybe the company has no debt; is there an opportunity to borrow money to grow the company?
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