Liabilities and Net Worth

Liabilities and net worth are sources of cash listed in descending order from the most nervous and current creditors to mature obligations (current liabilities) to the least nervous and never due obligations (net worth). There are two sources of funds: lender-investor and owner-investor. Lender-investor consists of trade suppliers, employees, tax authorities, and financial institutions. Owner-investor consists of stockholders and principals who loan cash to the business. Both lender-investor and owner-investor have invested cash or its equivalent into the company; the only difference between the investors is the maturity date of their obligations and the degree of their nervousness.

Current Liabilities

Current liabilities are those obligations that will mature and must be paid within 12 months. These are liabilities that can create a company's insolvency if cash is inadequate. A happy and satisfied set of current creditors is a healthy and important source of credit for short-term uses of cash (inventory and receivables). An unhappy and dissatisfied set of current creditors can threaten the survival of the company. The best way to keep these creditors happy is to keep their obligations current. Current liabilities consist of the following obligation accounts:

• Accounts Payable - Trade (A/P)
• Accrued Expenses
• Notes Payable - Bank (N/P Bank)
• Notes Payable - Other (N/P Other)
• Current Portion of Long-term Debt

Proper matching of sources and uses of funds requires that short-term (current) liabilities must be used only to purchase short-term assets (inventory and receivables).

Notes Payable

Notes payable are obligations in the form of promissory notes with short-term maturity dates of less than 12 months. Often, they are demand notes (payable upon demand); other times they have specific maturity dates (30, 60, 90, 180, 270, and 360-day maturities are typical). The notes payable always include only the principal amount of the debt. Any interest owed is listed under accruals.

The proceeds of notes payable should be used to finance current assets (inventory and receivables). The use of funds must be short-term so that the asset matures into cash prior to the obligation's maturation. Proper matching would indicate borrowing for seasonal swings in sales, which cause swings in inventory and receivables, or to repay accounts payable when attractive discount terms are offered for early payment.

Accounts Payable

Accounts payable are obligations due to trade suppliers who have provided inventory or goods and services used in operating the business. Suppliers generally offer terms (just like you do for your customers), since the supplier's competition offers payment terms. Whenever possible, you should take advantage of payment terms, as this will help keep your costs down.

If the company is paying its suppliers in a timely fashion, days payable will not exceed the terms of payment.

Accrued expenses are obligations owed but not billed, such as wages and payroll taxes or obligations accruing, and not yet due, such as interest on a loan. Accruals consist chiefly of wages, payroll taxes, interest payable, and employee benefits accruals such as pension funds. As a labor-related category, it should vary in accordance with payroll policy (i.e., if wages are paid weekly, the accrual category should seldom exceed one week's payroll and payroll taxes).

Non-Current Liabilities

Non-current liabilities are those obligations that will not become due and payable in the coming year. There are three types of non-current liabilities: non-current portion of long-term debt (LTD),  subordinated officer loans (Sub-Off), and contingent liabilities.  However, only two of these are listed on the balance sheet. 

Non-current portion of long-term debt is the principal portion of a term loan not payable in the coming year; subordinated officer loans are treated as an item that lies between debt and equity. Contingent liabilities listed in the footnotes are potential liabilities which hopefully never become due. Non-current portion of long-term debt (LTD) is the portion of a term loan that is not due within the next 12 months; it is listed below the current liability section to demonstrate that the loan does not have to be fully liquidated in the coming year. Long-term debt (LTD) provides cash to be used for a long-term asset purchase - either permanent working capital or fixed assets.

Notes payable to officers, shareholders, or owners represent cash which the shareholders or owners have put into the business. For tax reasons, owners may increase their equity investment beyond the initial company capitalization by making loans to the business rather than purchasing additional stock. Any return on investment to the owners can therefore be paid as tax deductible interest expense rather than as non-tax deductible dividends.

When a business borrows from a financial institution, it is common for the officer loans to be subordinated or put on standby. The subordination agreement prohibits the officer from collecting his or her loan prior to the repayment of the institution's loan. When on standby, the loan will be considered as equity by the financial institution. Notice that notes receivable to the officer are considered a bad sign to lenders, while notes payable to the officer are considered to be reassuring.

Contingent liabilities are potential liabilities that are not listed on the balance sheet. They are listed in the footnotes because they may never become due and payable. Contingent liabilities include:

• Lawsuits
• Warranties
• Cross Guarantees

If the company has been sued but the litigation has not been initiated, there is no way of knowing whether or not the suit will result in a liability to the company. It will be listed in the footnotes, because while not a real liability, it does represent a potential liability which may impair the ability of the company to meet future obligations. Alternatively, if the company guarantees a loan made by a third party to an affiliate, the liability is contingent because it will never become due as long as the affiliate remains healthy and meets its obligations.

Total Liabilities

Total liabilities represents the sum of all monetary obligations of a business as well as all claims creditors have on its assets.

Equity

Equity is represented by total assets minus total liabilities. Equity or net worth is the most patient and last to mature source of funds. It represents the owner's share in the financing of all assets.

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