Current liabilities are short-term financial obligations of a company that must be paid off within one year or a single operating cycle of the business. Current liabilities are recorded on the balance sheet and summarize the short-term dues of a company - something that is essential to know for business owners, lenders, investors, and financial analysts.
Highlights/ Key Takeaways
- Current liabilities of a company are short-term financial obligations that must be paid off within a normal operating cycle or within one year.
- Current liabilities are often covered with current assets, which are a company’s resources that are converted into cash or equivalents within one year.
- Common current liabilities examples include short-term debt, Accounts Payable, notes payable, dividends, and income taxes owed.
- Properly recording and analyzing current liabilities on a balance sheet is important, as it provides an overview of a company’s solvency and overall financial health.
What Are Current Liabilities?
Current liabilities on the balance sheet are short-term debts or financial obligations that a company must settle within one normal operating cycle or one fiscal year, whichever is longer. An operating cycle, also known as a cash conversion cycle, is the time required for a company to stock inventory and sell it, converting it to cash.
Current liabilities are listed on the right side of the balance sheet under the “Liabilities” section, from the shortest-term to the longest-term. Most balance sheets will include a separate section for long-term or non-current liabilities - those that must be settled in more than one year.
“Current liabilities on a balance sheet are short-term debts or financial obligations that a company must settle within one normal operating cycle or one fiscal year, whichever is longer.”
How Do Current Liabilities Work?
In general, current liabilities are used by accountants, analysts, business managers, investors, and lenders to evaluate how well a company can meet its short-term financial obligations. However, the exact treatment of current liabilities can vary from company to company, based on the industry or sector the company operates in.
Paying current liabilities is mandatory for any company. This means that the total value of current liabilities shows how much revenue and cash a company needs to generate in the short term to cover its dues.
Numerous financial ratios use the value of current liabilities in their calculations to estimate how leveraged a company is and whether it is able to repay its debts. Ideally, a business should have sufficient assets to cover its current liabilities and even have some money left over. If this is the case, the company is in a strong position and will be able to withstand unexpected changes in the next twelve months.
Why Do Current Liabilities Matter?
Current liabilities are often analyzed by investors and creditors alike to gauge the financial position of the company in question. For instance, before deciding to extend credit, banks and other lenders need to know whether a company is getting paid for its accounts receivable on time, as well as whether it covers its payables. As such, they use ratios based on the value of current liabilities, such as Current and Quick Ratios, to analyze a company’s solvency and overall financial position.
Similarly, business owners and managers can use the current liabilities to evaluate the financial health of their company and plan for the future.
“Current liabilities are used by accountants, analysts, business managers, investors, and lenders to evaluate how well a company can meet its short-term financial obligations.”
Current Liabilities Types
All current liabilities can be divided into three broad categories or types. These include liabilities whose amount can be determined, liabilities that represent collections for third parties or depend upon operations, and contingent liabilities. Let us take a closer look at each of these current liabilities types.
Liabilities Whose Amount Can Be Determined
All current liabilities that are known and have a definite amount fall under this category. Some examples of definitely determinable current liabilities include Accounts Payable, Trade Notes Payable, Current Maturities of Long-Term Debt, Dividends Payable, and Interest Payable.
While determining the value of these liabilities does not present any challenge, they must still be identified and recorded in the proper accounting period.
Liabilities that Represent Collections for Third Parties or Depend Upon Operations
Companies are often required to make collections for third parties like governmental agencies or unions. For example, if taxes are levied on companies and/or citizens, then a firm may be required to collect these taxes on behalf of the taxing authority.
Some current liabilities included in this category are social security taxes, sales and excise taxes, withholding taxes, and union dues. Other types of liabilities, such as federal and state corporate income taxes, will depend on the company’s operations and profitability.
Contingent liabilities result from an existing situation or condition whose outcome depends on some future event. The actual amount of such liabilities cannot be determined until the said event occurs, which means that these liabilities must be estimated for accounting purposes. What’s more, many times, the actual payee of the liability is not known either until the future event occurs.
Some examples of contingent liabilities include pending litigation, product guarantees and warranties, and the guarantee of others’ indebtedness.
List of Current Liabilities
The list of current liabilities outlined below shows the vital components to account for.
Accounts Payable, often abbreviated as AP, represent a firm’s short-term debt obligations to its suppliers and creditors. In other words, this line item represents the total amount a company owes to vendors or suppliers for invoices that have not yet been paid.
Most of the time, vendors allow 15, 30, or 45 days for a customer to pay. This means that the buyer can receive the supplies but can pay the invoice at a later date. Such invoices, therefore, act as a short-term loan from a vendor and appear under Accounts Payable.
Some examples of items and services that fall under Accounts Payable include:
- Cleaning services
- Software subscriptions
- Office supplies
- Staff uniforms
Notes Payable are written agreements, in which one party (a company) promises to pay a certain amount of money to the other party (its financier). In other words, these are promissory notes that describe the terms of a loan between two parties. Notes Payable are often long-term but, if the maturity date is within twelve months, they can fall under current liabilities.
Examples of current Notes Payable include:
- Receiving a loan from a bank
- Obtaining a company car
- Purchasing a building
Accrued Expenses are costs that are recorded on the balance sheet but have not yet been paid. Such expenses use the accrual method of accounting, which means that they are recognized at the time they are incurred rather than at the time they are paid.
Accrued Expenses represent short-term financial obligations and, therefore, are listed under the current liabilities section of the balance sheet. Typically, businesses use current assets such as cash and equivalents to cover Accrued Expenses.
Common examples of Accrued Expenses are:
- Wage expenses
- Loan interest
- Payments owed to vendors and contractors
- Rent expenses
- Utility expenses
- Government taxes
Every company owes several types of taxes, which are recorded under short-term liabilities. The most common business taxes in the U.S. are:
- Payroll taxes that have been withheld from an employee but have not yet been paid
- Income taxes owed to the government
- Sales taxes collected from customers that must be paid to the government
The short-term debt liability represents the total sum of debt payments owed within the next year. This short-term debt value is often compared to long-term debt when analyzing a company’s financial position.
Short-term debt types include:
- Commercial paper
- Short-term bank loans
- Overdraft credit lines for bank accounts (these might be recorded as separate line items)
- Current portion of long-term debt due within one year (this can also be recorded on a separate line)
Bank Account Overdrafts
Bank Account Overdrafts are short-term advances issued by the bank to compensate for any account overdraft caused by issuing checks in excess of available funding. In other words, if you spend more than you have in your current bank account, the bank will cover the difference in the short term, - usually, there will be a charge for this.
Current Portion of Long-Term Debt
Long-term liabilities or debts are the money a company owes to third-party creditors that must be repaid in longer than twelve months. The Current Portion of Long-Term Debt (CPLTD) is the amount of unpaid principal from long-term debt that has accrued during a company’s normal operating period (usually less than twelve months). This amount must be paid in that time period and is, therefore, considered a current liability.
Many companies are responsible to cover payroll liabilities that are due within one year. These are the payroll expenses that a business owes but has not yet paid; many of these expenses will appear every time a business runs payroll.
Common examples of payroll liabilities include:
- Medicare charges withheld from employees
- Employer benefits such as health insurance premiums
- Employer retirement plan contributions
Dividends are cash payments issued by companies to their shareholders as a reward for purchasing and investing in their stock. If a company’s board of directors declares dividends to be paid out to shareholders in the next twelve months, they will be recorded as current liabilities.
Unearned Revenue or Customer Deposits
Unearned Revenue or Customer Deposits is money paid to an enterprise for a service or product that has not yet been provided or delivered. In a nutshell, unearned revenue is a type of debt owed to the customer, which means that it is a current liability. Once the service has been provided or a product has been delivered, the Unearned Revenue is recorded as general revenue on the income statement.
A few typical examples of Unearned Revenue are:
- Prepaid insurance
- Advance rent payments
- Annual software subscriptions
- Airline tickets
Current Lease Payable
A lease payment is similar to monthly rent, formally outlined in a contract between two parties. The contract provides one party with the legal right to use the other participant’s real estate properties, computers, manufacturing equipment, software, or other fixed assets for a specified period of time. Current Lease Payable stands for the lease obligations due in the short-term, or in the next twelve months.
Some examples of items that fall under Current Lease Payable are:
- Current portion of the lease payment for an office space
- Current portion of the lease payment for machinery or equipment
- Current portion of the lease payment for computers or software
How to Calculate Current Liabilities
Current liabilities on the balance sheet must be calculated and managed prudently to ensure that the company has sufficient current assets to cover the dues.
Current Liabilities Formula
To calculate the total current liabilities, you would need to simply add up all the types of current liabilities your company has:
Current Liabilities = Accounts Payable + Notes Payable + Accrued Expenses + Unearned Revenue + Short-Term Loans + Current Portion of Long-Term Debts + Other Short-Term Debts
Here, Other Short-Term Debts can include Payroll Liabilities, Dividends Payable, Bank Account Overdrafts, and more.
Example Current Liabilities Calculation
Suppose Company ABC has the following current liabilities:
Accounts Payable: $3,500
Short-Term Loans: $15,000
Accrued Expenses: $4,500
Current Lease Payable: $36,000
Payroll Liabilities: $25,000
Current liabilities can then be calculated by adding all the short-term liabilities together:
Current Liabilities = $3,500 + $15,000 + $4,500 + $36,000 + $25,000 = $84,000
“To calculate the total current liabilities, you would need to simply add up all the types of current liabilities your company has.”
Accounting for Current Liabilities
Every business must keep track of current liabilities and record them accurately on the balance sheet. That way, relevant financial ratios can be easily and accurately calculated, providing insight into the financial position of the company.
How to Record Current Liabilities
Whenever a company receives an economic benefit that must be paid off within a year, it must immediately record it as credit under current liabilities. Depending on the nature of the received benefit, it may also be classified as an asset and recorded as a debit entry.
To make it clearer, let us take a look at an example of how a company would record current liabilities.
Suppose a bicycle store receives a shipment of bicycles and must pay $10,000 to the suppliers within the next 30 days. In that case, the $10,000 owed will be recorded as credit under Accounts Payable. At the same time, this amount will be recorded as an asset under Inventory.
Once the company pays the balance due to the suppliers, the Accounts Payable are debited by $10,000. At the same time, the Cash account is credited $10,000.
How Current Liabilities Can Be Used
Analysts and creditors use different metrics and ratios based on current liabilities to gauge a company’s financial solvency and how well it manages its payables. Common metrics include Working Capital, Current Ratio, Quick Ratio, and Cash Ratio.
Typically, current liabilities are covered by current assets such as cash and cash equivalents. Whatever is left is referred to as “working capital”:
Working Capital = Current Assets - Current Liabilities
Calculating a company’s working capital provides important insights into its liquidity position. A good working capital value will be positive, but not excessive. While excessive working capital might seem like a good thing, it means that the current assets significantly exceed the current liabilities on the balance sheet. This excess capital stuck in the assets has an opportunity cost, meaning that it could be invested somewhere else and generate more profits.
On the other hand, insufficient working capital can indicate that a company does not have enough assets to meet its current liabilities, leading to short-term liquidity problems. Consistent liquidity problems can negatively affect the company’s operations and even its credibility on the market.
The Current Ratio is another metric often used by creditors and analysts to measure a company’s ability to cover its short-term financial obligations. The ratio is calculated by dividing total current assets by total current liabilities:
Current Ratio = Current Assets / Current Liabilities
This value shows how well a company manages its balance sheet and whether it has enough current assets to pay off its current debts. Ideally, the Current Ratio should be higher than one, demonstrating that the value of current assets exceeds the value of current liabilities.
The Quick Ratio calculation is similar to the Current Ratio calculation, except that the value of inventories is subtracted beforehand. The Quick Ratio only includes the current assets that can be quickly converted into cash to pay off short-term liabilities, which makes it a more conservative measure of liquidity.
Quick Ratio = (Current Assets - Inventory) / Current Liabilities
Similarly to the Current Ratio, the Quick Ratio should ideally be higher than one.
The Cash Ratio is another liquidity measure showing the company’s ability to cover its short-term obligations. It can be calculated by finding the total cash and cash equivalents and dividing the result by current liabilities.
Cash Ratio = (Cash + Cash Equivalents) / Current Liabilities
Unlike other metrics, the Cash Ratio focuses on only cash and cash equivalents and depicts whether the company has enough cash to cover its current liabilities.
Current Liabilities and Related Terms
Current liabilities are recorded on the right side of the balance sheet along with non-current liabilities. Current and non-current assets are recorded on the left, with owner’s equity calculated as the difference between total liabilities and total assets. Let’s examine how current liabilities can be distinguished from related terms.
Current Liabilities vs Non-Current Liabilities
Recall that current liabilities are short-term debt that a company must pay off within one year or its normal operating cycle. If liability has a longer term, it is called a long-term or non-current liability and is recorded under the Non-Current Liabilities section on the balance sheet.
For example, a short-term loan that must be repaid within six months is considered a current liability. However, a loan that must be repaid in three years is a non-current liability.
Current Liabilities vs Current Assets
While current liabilities are obligations that are expected to be paid within one year, current assets are valuable resources that can be converted into cash within the same time period. Assets that cannot be converted into cash as quickly are called “non-current assets.”
For example, the invoices due to be paid for business inventory are recorded under current liabilities. However, the inventory itself falls under current assets. Similarly, Accounts Payable are current liabilities, while Accounts Receivable are current assets.
To summarize, current liabilities on the balance sheet are short-term debts and other financial obligations that a firm must repay within one year of one operating cycle, whichever is longer. Every business owner must track and accurately record current liabilities; furthermore, special financial metrics and ratios can be used to gauge the company’s solvency and overall financial health.