You may have a debt-free business, but that doesn’t mean your business doesn’t have liabilities. The definition of liabilities goes beyond debt and includes any financial obligation your business has to pay within one year or a normal operating cycle. It is called liabilities as you are liable to pay someone, be it lenders, suppliers, customers, Canada Revenue Agency (CRA), or employees. Like liabilities, a current asset is any transaction that ensures the business has or will receive money within a year.
Since business involves a lot of cash inflow and outflow, maintaining a smooth cash flow requires balancing current liabilities and assets. Today, we will discuss why small businesses must understand and manage their current liabilities effectively.
Understanding Your Current Liabilities
Every business has a different capital and operating structure. Some have high debt, some operate on revolving credit, and some take advanced payments. Your current liabilities define the nature of your business and the credit risk involved.
Deferred Revenue: For instance, a magazine might take annual subscriptions, or travel agents might take payments before incurring tour expenses. These advance payments are categorized under deferred revenue in current liabilities. Here, you are liable to provide services to the customer. Hence, you will deduct monthly revenue and slowly phase out your deferred revenue.
Debt: Let’s take the example of a capital-intensive business having significant debt. The current liabilities include all the interest and debt payments due in a year. It is further divided into short-term debt and the current portion of long-term debt. This segment is crucial as you should have sufficient cash to service this debt. If you are facing a shortage, you might look for alternatives to finance this liability. You can consider talking to the bank/lender to adjust the payments. Another option is to take a new loan to repay the old loan.
Tip: Any defaults can negatively impact your credit score and reduce your chances of getting favourable credit terms. Prioritize repaying debt that carries high interest and is not tax deductible.
Accounts Payable: While the above liabilities depend on your business and capital structure, accounts payable is a liability every business has. As the name suggests, it includes all bills to suppliers and vendors. This liability is financed from accounts receivable. You can use these two amounts to determine your liquidity ratio (Accounts Receivables/Accounts Payable).
A 1:1 ratio shows you don’t have much flexibility. The payments you receive from clients will go into making payments to suppliers. Higher accounts payables might require you to arrange for some money.
Accrued Liabilities: Like accounts payable, any expenses you have accrued but not paid, like wages, taxes, and interest, will be added to current liabilities as you will have to pay them in the near future.
Other current liabilities: There are contingent liabilities besides the above four. These are unexpected expenses, such as a lawsuit or a natural calamity, and can be financed from insurance or cash reserves. Sometimes, hefty contingent liabilities can hurt your profits.
Managing Your Current Liabilities
Understanding your current liabilities can give you a fair idea of how to fund your payments. While classifying them into the right bucket is important, it is equally important to measure the realizable value.
Some current liabilities have a fixed value, like accrued salary and the current portion of your long-term debt. But if that debt has a variable interest rate, the payments might change. But most liabilities are variable, such as your payables and income tax. When you have a fair idea about upcoming liabilities and the available liquidity, you can plan to incur a significant capital spend or declare a dividend.
If you use up your cash to buy equipment without looking at your current liabilities, you might be cash-strapped and have to take a loan. If your current assets are double or triple the size of your current liabilities, you know you have the financial flexibility to make significant investments or go ahead with the expansion plan. And if there are no good investment opportunities, you can use the surplus to repay debt or give dividends.
Balance sheet plays a crucial role in business planning and debt restructuring.
Contact Glenn Graydon Wright LLP in Oakville to Help You with Your Accounting Needs
A skilled accountant can help you prepare your balance sheet, analyze the figures, and suggest measures to maintain a healthy balance sheet with financial flexibility. To learn how Glenn Graydon Wright LLP can provide you with accounting services, contact us online or by telephone at 905-845-6633.