What are Liabilities?
Liabilities are unsettled obligations to third parties that represent a future cash outflow — or more specifically, the external financing used by a company to fund the purchase and maintenance of assets.
Liabilities Definition in Accounting
Liabilities are the obligations of a company that are settled over time once economic benefits (i.e. cash payment) are transferred.
The balance sheet is one of the core financial statements and consists of three sections:
- Assets — The resources with economic value that can be sold for money upon liquidation and/or are anticipated to bring positive monetary benefits in the future.
- Liabilities — The external sources of capital used to fund asset purchases, like accounts payable, loans, deferred revenue.
- Shareholders’ Equity — The internal sources of capital used to fund its assets such as capital contributions by the founders and equity financing raised from outside investors.
The values listed on the balance sheet are the outstanding amounts of each account at a specific point in time — i.e. a “snapshot” of a company’s financial health, reported on a quarterly or annual basis.
The fundamental accounting equation is shown below.
- Total Assets = Total Liabilities + Total Shareholders’ Equity
If we rearrange the formula around, we can calculate the value of liabilities from the following:
- Total Liabilities = Total Assets – Total Shareholders’ Equity
The remaining amount is the funding left after deducting equity from the total resources (assets).
Purpose of Liabilities — Debt Example
The relationship between the three components is expressed by the fundamental accounting equation, which states that the assets of a company must have been financed somehow — i.e. the asset purchases were funded with either debt or equity.
Unlike the assets section, which consists of items considered to be cash outflows (“uses”), the liabilities section is comprised of items deemed to be cash inflows (“sources”).
The liabilities undertaken by the company should theoretically be offset by the value creation from the utilization of the purchased assets.
Along with the shareholders’ equity section, the liabilities section is one of the two main “funding” sources of companies.
For instance, debt financing — i.e. the borrowing of capital from a lender in exchange for interest expense payments and the return of principal on the date of maturity — is a liability since debt represents future payments that will reduce a company’s cash.
However, in exchange for incurring the debt capital, the company obtains sufficient cash to purchase current assets like inventory as well as make long-term investments in property, plant & equipment, or “PP&E” (i.e. capital expenditures).