What Is a Liability in the Stock Market?

Do you know the liabilities definition? Most of us are familiar with liabilities dating back from our Accounting 101 classes. One of the most popular formulas in that class was Assets = Liabilities + Shareholder’s Equity from the balance sheet. We covered assets in a different article. Now, it’s time to expand on the liabilities section of this financial statement. Some companies only have a $1,000 debt on a credit card. Meanwhile, most multinational public companies have much, much more than that. Let’s take a look at different kinds of debt owed by big companies and their different uses as we learn the liabilities definition.

What Is a Liability?

Liabilities Definition

Let’s start off learning the liabilities definition. Most liabilities are separated between current liabilities, which are short-term, so due in less than 12 months, and non-current liabilities, which are due in more than 12 months.

Liabilities can include debt, bonds, mortgages, accounts payable and many more. Further down, we will take a deeper look into those more in detail. 

Companies in different stages of growth will have different debt vehicles. A startup will have much more debt than a market leader. Some public companies aren’t profitable even years after they become public.

Some popular examples are Airbnb (NASDAQ: ABNB), Uber (NYSE: UBER) and Lyft (NASDAQ: LYFT). Basically, the majority of LUPA stocks

Why Do Companies Take out Debt?

To make money, it takes money. However, when you don’t have any, or enough to start a successful business, it becomes necessary to borrow. Before taking the big leap into the stock market and becoming a public company, companies are private.

It’s much easier and quicker to receive funding as a private company as long as the business plan is solid and unique. Banks are often reluctant to loan money to unproven companies with little or no track record.

Liabilities Definition of Private Placement

Enter private placements from venture capital companies, crowdfunding or private investors. The terms and amounts can make a difference. Why do companies take out debt?

Salaries & Benefits: Unless the business is run only by the founders, it’s necessary to pay the employees. This can be in form of a salary, stock benefits or options. To keep quality employees, the pay structure has to be competitive and the business needs a solid plan. All this requires money.

Infrastructure and Equipment: Debt can also fund the purchase of various equipment and infrastructure necessary to run and grow the business.

Mergers & Acquisitions: M&As are a very popular use of borrowed funds. They allow a company to grow in the same or complementary segment.

Research & Development: R&D allows companies to release new and improved products on the market. Two great recent examples are Pfizer (NYSE: PFE) and Moderna (NASDAQ: MRNA). They quickly began R&D to release a vaccine available in large quantities. The same can be applied to most industries.

Companies that efficiently allocate their borrowed funds have a greater chance to succeed as a private or public company. Those who use those funds to pay top management or give out bonuses are only there to get richer instead of investing in the business.

Before investing in a company, it’s important to look at its debt structure (types of liabilities) and its different uses for it.

Liabilities Definition of Types

Liabilities Definition

Accounts Payable: This category is usually short-term debt. It includes wages, interest, dividends, income taxes and what is due to the vendors. 

Unearned Revenues: When a company receives payment for a service or goods delivered in advance, it is first counted as a liability. Once it is delivered, the amount will be offset.

Discontinued Operations: When an operation is no longer profitable, it can be discontinued. Examples can be the closing of a production facility or the discontinuation of a product. Growing companies are much more affected by this. In recent years, many cannabis companies opened too many facilities. They ended up being unsustainable and they had to close down. The companies and their shareholders lost a lot of money that could have been used much more efficiently. Companies are required to disclose the financial impact of such operations.

Short-term Debt: Current debt is due in less than 1 year. This includes lines of credit and short-term loans.

Long-term Debt: Non-current debt is due in more than 1 year. This includes mortgages, bonds and notes payable. The last 2 items are often two of the biggest components of the liabilities section. 

Contingent Liabilities: This is reserved for events that may occur depending on future events. 

Why do companies who have cash reserves take out loans instead? The answer is quite simple. A small collateral can be used to take out much bigger loans. It becomes easier to grow the company. Let’s take a look at a few companies 

When Is there Too Much Debt?

Debt

Unfortunately here, the answer isn’t always straightforward with the liabilities definition.

Many factors come in place. One of the most important is a balance between short-term and long-term debt.

Too much debt due in less than 12 months is unsustainable. At the same time, too much long-term debt with high-interest rates is as well. There must be a balance between short-term, long-term debt, lines of credit and other debt instruments to have some diversification.

Yes, diversification isn’t only for investors. It is also very useful for companies and their debt structure. Thankfully, we can perform a fundamental analysis thanks to a few ratios. They allow us to compare companies in the same industry.

Liabilities Definition of Current Ratio

First, the current ratio is obtained by dividing the current assets by the current liabilities. Quick reminder, current debt is due in less than 1 year. Current assets are very liquid. They can be transformed into cash almost immediately. This includes cash, accounts receivables, inventory and liquid investments.

It determines the capacity of paying current debt with current assets. A ratio below 1 indicates that a company can pay all its short-term debts with no issue.

On the other hand, a ratio above 1 indicates a potential risk. There may not be enough cash to pay its current debt. 

Liabilities Definition of Debt Ratio

Next, the debt ratio is derived by dividing total debt by total assets. In an ideal world, the number obtained is below 1. In that case, the company has more assets than debt. Unfortunately, it isn’t always the case. Newer companies usually have more debt than assets.

They’re still at the beginning of their lifecycle and need to finance operations as quickly as possible. This requires a lot of money.

Many other useful ratios exist. It can be useful to have a basic understanding of them to compare companies in the same field. Some stocks may be undervalued when we compare these ratios.

Now You Know What Liabilities Are

To conclude the liabilities definition, they’re an important factor in a company’s success. In fact, it’s essential to choose the right mix of short-term and long-term liabilities.

It’s also important to use the debt efficiently. The management of new companies often makes crucial mistakes when it’s time to allocate the funds. Many ratios exist to help investors choose between many companies in the same industry.

They’re easy to compare and easy to understand. Making the right stock picks doesn’t only come to liabilities. There are a plethora of other factors to consider. Thankfully, we can help with our online courses, tools and trading techniques. You can take a look over here.

Leave a Reply

Your email address will not be published.