As a startup business, balancing your liabilities to favor your business is essential. Liabilities, in short, are the debts that a company acquires over time. Navigating through long-term and short-term debt is vital in ensuring that your business not only runs successfully but can also be profitable in the future.
A more extensive explanation is that liabilities are legal debts that a company owes to third-party creditors. Liabilities include but are not limited to bank overdrafts, accounts accrued, as well as notes payable. A proper balance of liabilities and equity will provide a stable foundation for your company.
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Here is the content that we will cover in this post. Let’s get started.
- 1. How Do Business Liabilities Work?
- 2. The Difference Between A Liability And An Expense
- 3. Benefits and Disadvantages To Liabilities
- 4. The Importance Of Business Owners Understanding Liabilities
- 5. Liabilities You Should Try To Avoid As A Business Owner
- 6. What Liabilities Should You Have As A Business Owner?
- 7. How To Identify Liabilities In A Balance Sheet
- 8. How To Reduce and Manage Your Liabilities as A Startup Business
How Do Business Liabilities Work?
When you purchase something for your business, whether a service or a product, you can use various options to pay for it, for example, you can pay using cash from a checking account, you can take a loan, or you can borrow money to cover the cost if you need more money than what you currently have.
As you build your new business, it is essential to remember that any money that you borrow will create a claim on your business and your assets from the third party you borrow the money from. Therefore, buying on credit or loan represents a liability for your company, as it is a debt that your business must pay back.
There are three different types of liabilities that a business can incur and they are as follows.
Short Term Liabilities
These liabilities are also known as current liabilities. These are liabilities that are due and paid over 1 to 2 years. Examples of short term liabilities can include the following:
- Short term loans
- Accrued expenses
- Accounts payable
- Bank overdrafts
- Bills payable
- Income tax and interest payable
Long Term Liabilities
Also known as non-current liabilities are long-term financing projects for your new business. Long-term liabilities are debts that are repayable for periods that extend longer than 1 to 2 years.
Long-term debt or liability is usually taken on by a business to secure venture capital that is necessary to expand and grow. Whether the money is used to purchase assets or finance new projects, long-term liabilities are usually taken to fund growth or expansion in a new direction.
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Long term liabilities include:
- Deferred tax liabilities
- Long term notes
A contingent liability is one that may arise as a result of a future event. They are known as potential liability and are usually only considered in the most probable cases. In short, contingent liabilities are liabilities that occur in the case of failure of a product or service that may result in a hefty cost. Contingent liabilities are often covered by insurance but include the following:
- Possible lawsuits
- Pending investigations
- Product warranties
The Difference Between A Liability And An Expense
To put it short and sweet, the difference between an expense and a liability is:
- Expenses refer to the costs that are accrued by your business generated as it conducts business. These are costs such as wages, leases, the depreciation that occurs to equipment, and payments that you must make to suppliers.
- On the other hand, Liabilities refer to debt owed, usually in a monetary form, and are settled or paid overtime.
As a startup company, your expenses would cover inventory, salaries and wages, equipment, marketing, and social media management, website management, etc. Whereas your liabilities may include items such as a mortgage, a loan, and even deferred income taxes.
Realistically speaking, even long-standing companies sometimes struggle to operate under all of their liability on their business. Thus it is imperative that as a startup company, you can differentiate between an expense and a liability so that you know the possible long-term effects and long-term debt you may be agreeing to.
Benefits and Disadvantages To Liabilities
Taking on liability as a new business can be tricky, and if it is not properly assessed, the risk can far outweigh the reward. Taking a chance when the reward is high is regarded as a high-risk decision in the business world. High-risk decisions are often taken because the reward is worth risking failure. Medium to high-risk choices usually leaves a business with room to grow, as the company has identified additional areas in which it could thrive and expand.
Alternatively, taking little to no risk leaves your business with no room to grow. When your business becomes stagnant, the threat of new competitors that could sink your company is high, and the reward of taking no risk no longer becomes worth it.
To determine whether or not a liability is worth having, you should consider the pros and cons of agreeing to take on such liability.
- Expanding your business into new areas through the venture capital gained from the liability.
- Economists and investors sometimes view the liabilities a company has as an indicator of the status of its financial health.
- Liabilities can be used to purchase new equipment or tools necessary to operate the business.
- Fewer investment opportunities. Investors sometimes prefer to work with companies that have a higher asset to liability ratio in their company.
- High-interest rates. A primary downside to taking on liability is that the liability may charge a significant interest rate on the amount of money that is essentially being borrowed.
- Repayments. Over a long time, high reimbursement rates can affect the profitability of your business. The more money and debt you accumulate, the less money you will have to achieve a profit.
- Liabilities that are paid back can be good for your company’s fiscal health. However, liabilities that are paid back in an untimely manner can impact your business’s credit rating.
The Importance Of Business Owners Understanding Liabilities
All business owners should know more about the liabilities and assets of their business because it affects the longevity and continuity of your business. The number of assets your startup has should always outweigh the liabilities.
Having the assets outweigh the liabilities indicates to potential and current investors, as well as your company itself, that the business is performing well enough to sustain the short and long term liabilities it currently has.
The better you understand your company’s liabilities and how they operate, the easier it will be to create a system in which your business will be able to pay back the money it owes both in the short run and the long run.
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Liabilities You Should Try To Avoid As A Business Owner
Your business will eventually need to incur some liability. Whether you need liability in the form of a loan or a mortgage payment, you will need to develop and grow your business, and liabilities can help you do this.
As a new business owner, you should look to avoid the following liabilities:
- Liabilities With High-interest rates: Liabilities with high-interest rates will often mean that you will have to pay an excessive amount of money. Where possible, it is best to avoid taking on liabilities with high-interest rates because the risk is not worth the reward.
- Over Excessive Liabilities: Avoid the common pitfall of taking on one too many liabilities. While liabilities and the repayment of liabilities indicate how solvent your business is, too many liabilities will sink your business.
What Liabilities Should You Have As A Business Owner?
There are many various liabilities that you can incur as a new business owner. From short-term to long term, and even contingent liabilities. Here are a few of the liabilities you can expect to have as a new business owner:
- Wages owed
- Vendor credit
Liabilities are not all bad. For new or startup businesses, good liability can be an absolute game-changer. Good liability is known as good debt. Good debt is often usually referred to as money that relatively small companies borrow or loan in order to contribute to their development and growth positively.
In general, good debt is debt that contributes to the increase of the overall net worth or cash flow of your business.
This could be money that is borrowed for the expansion of the business, or cash used to purchase better technology and equipment, or a mortgage loan, and it could even be money used to restructure your business safety regulations. The list for the use of the money is endless.
Whether short-term or long-term, liabilities that are paid back within a reasonable time frame are referred to as good debt. This liability is suitable for your business because it has helped your business grow and shows possible investors that your company has a favorable payment history. In addition, having a good payment history showcases that you can responsibly handle debt and will have a positive impact on your credit score, and enable you to secure better loan agreements in the future.
How To Identify Liabilities In A Balance Sheet
There are many different types of liabilities that businesses have. These liabilities include:
- Accounts payable
- Interest owed
- Lease agreements
- Accrued liabilities
The list of possible liabilities that a business can accrue is endless. When compiling and identifying the liabilities that your more business has, it is essential to do the following:
- Create a balance sheet
- Review the different liabilities your company has (short term and long term liabilities)
- Review the debts you still have to pay back
- List your short-term debts and long-term debts under a different liability type according to the payment period of your liability.
The trick to identifying the liabilities in your balance sheet is to identify and list the liabilities according to the debts that your business has to pay. When you calculate the total amount of debt and repayments your business has to make, separate them according to the type of liability.
Your loans and debts repayable need to be sorted according to the different liability types your business has. It is broken down according to each account you have and the money that is still owed. Calculating the cost of all of your liabilities is easy once you have identified them.
How To Reduce and Manage Your Liabilities as A Startup Business
Reducing the overall amount of risk your company faces, especially as a startup business, is essential and can be what helps you to forge a successful path forward in the business world. While not all liabilities are bad for your business, limiting the amount of liability your business has can help you save the hassle and financial troubles further down the line.
A few ways in which you can limit the liabilities and risk for your business are:
- Know and be conscientious of your cash flow. Cash flow is the only way to keep any business above water, and for small businesses, cash flow is the life source of the company. Ensure that you have good accounting practices in place and follow monthly budgets that are realistic to your business.
- Have good insurance. Insurance may seem like a significant expense to a new company, but it is a vital one. Are your staff covered against injury? What happens if your property becomes damaged? Do you have insurance against personal damage? Protecting yourself and your business in case something goes wrong is a good practice to have.
- Employ reasonable online security measures. New businesses, especially tech startup companies, need to ensure that online security measures are in place. This limits the risk and exposure of confidential information of the business and the clientele.
Overall, liability within a business can often be a good thing. It could even be the push that your business needs to go into a new and exciting venture. However, to work with liabilities consistently and successfully, make sure that you do not overextend your business’s financial constraints. Liabilities can help you reach your potential when managed wisely.
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