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Balance sheet 101: Understanding liabilities

Insights into the liabilities part of the balance sheet to know what it communicates and how to make use of it

Balance sheet 101: Understanding liabilities

"10% of the borrowers in the world use debt to get richer; 90% use debt to get poorer."
-Robert Kiyosaki

Like the asset side of the balance sheet, the liabilities side is an enumeration of all the different forms of liabilities that are payable by a company. It is arguably even more important than the asset side, as the asset side represents optimism, while the liability side, more often than not, pulls a company back to ground reality. Debt is the primary reason behind companies going bankrupt. After all, if a company does not have any debt, it will simply never go bankrupt.

As we have mentioned in the first article 'Balance sheet 101: Introduction', the liabilities side of the balance sheet gives a better understanding of how much of the total assets owned by a company has actually been paid for with the company's own money as against borrowed money.

Like assets, liabilities of a company are also classified into two categories - current liabilities and non-current liabilities.

Current liabilities
The current liabilities section contains the debts that are payable by a company in the normal course of its operating cycle and that have to be settled in the next 12 months. Apart from short-term borrowings, this section includes that portion of long-term obligations which are payable in the near future. Short-term provisions, trade payables and rent obligations are normally classified as current liabilities.

What current liabilities tell us
The study of the current liabilities section helps gauge the immediate threats to the company's ability to function. When there are disruptions in the market environment, it is important to understand the magnitude of a company's short-term obligations. Current liabilities have to be studied in conjunction with current assets to get a clearer picture of the company's financial position and make sure that there are adequate assets to pay off the liabilities as and when they arise. Companies should ideally make their business plans in such a way that their investments mature around the same time as the liabilities come due.

Non-current liabilities
As the name implies, all those liabilities that are not classified as current liabilities are classified as non-current liabilities. These liabilities have a much longer time horizon and represent more stable sources of borrowing. When companies invest in large operational assets (think of factories, roads, aircraft, etc.) which usually have a long lifetime, they should ideally be funded with long-term liabilities so as to avoid the risk of refinancing at unfavourable conditions.

What non-current liabilities tell us
Paying attention to this section is important for two reasons - (1) non-current liabilities, together with the current liabilities, give the true picture of how indebted a company is and (2) this section, when read with the asset section and considering the nature of assets and the proportion of assets funded by long-term sources, helps us understand the stability of the capital structure and the degree of asset-liability mismatches if any. While mismatches can happen in both current and non-current portions of assets and liabilities, it would be more difficult to correct the long-term mismatches than the short-term ones.

Investor takeaways
For investors, examining the liabilities side of the balance sheet is not a one-time exercise at the time of investment. Instead, this activity of monitoring the liabilities should be done at regular intervals throughout the duration of the investment period. It is noteworthy that the figures are easily accessible on the website of Value Research. The general thumb-rule is that less debt is better than more debt. And of all types of liabilities, long-term debt is preferable to short-term debt.

Other articles in this series

Balance sheet 101: Introduction

Balance sheet 101: Understanding assets