Liabilities are defined as an obligation to a third party.
Liabilities are a source of funds for a business (Yellow in Colour Accounting).
Examples of liabilities include: accounts payable (trade creditors), bank loan, holiday pay owing, and revenue received in advance.
Liabilities can be subcategorised into current and non-current: current liabilities will need to be paid within twelve months, non-current liabilities will be payable later than twelve months.
One ratio that helps us understand how liabilities are used to fund the assets in a business is the debt to assets ratio, also known as leverage.
Debt to Assets ratio/Leverage
Leverage is used to calculate the percentage of a business’ assets that are funded by third parties (instead of the owner). The formula is:
Total liabilities divided by Total assets x 100
A low percentage indicates a conservative balance sheet with little external funding i.e. a high proportion of the assets are funded by owner (equity).
A high percentage shows that much of the asset value is sourced from external funding, which could make it difficult for the business to access further debt in future.
Monitoring leverage is key for any business, but especially those with bank guarantees in place that may specify a limit on leverage as a condition of lending.
Insights from Justin Martin, Colour Accounting Facilitator