Updated July 5, 2023
Definition of Financial Liabilities
Financial liabilities are contractual obligations in which there is an outflow of any financial asset, including cash, to another entity due to a past transaction or an exchange of financial assets or liabilities with some other entity where the conditions are potentially unfavorable.
Explanation
The financial liabilities can be the following any of the following items:
- Any contractual obligation that results in the outflow of cash or some other financial asset to some other entity or exchange of financial assets or liabilities in potentially unfavorable conditions.
- In the case of a non-derivative contract, the business entity must deliver its variable number of equity instruments as settlement. In the case of a derivative contract, the business entity will likely settle it with its fixed number of equity instruments rather than cash or a similar asset.
Example of Financial Liabilities
- The dealer sold goods to Ltd. on credit for $5,000, and Ltd. owes $5,000 to the dealer, which is recorded as creditors in current liabilities after 1 month. So, payment to creditor i.e. dealer c, becomes the financial liability as payment to creditor results in an outflow of the asset i.e. cash.
- I purchased some items from a shopping mall and paid through a credit card. At the end of every month, the bill credit card is generated and will be paid by the 10th of the next month. So, credit card payment becomes a financial liability for Mrs. A as it results in an outflow of assets and cash.
- A company has to pay rent for occupying the office building to the owner of the building; hence the rent is classified as current or short-term liabilities, which results in the payment of cash. So rent is an example of financial liability.
- ABC bank granted a loan to B Incorporation, which B Incorporation is required to repay in equal monthly installments over a period of 5 years. As the repayment of the loan entails a cash outflow, it is treated as a financial liability. Additionally, since the loan includes an interest component and takes longer than 1 year to settle the liability, it is classified as a long-term financial liability.
- An Ltd sold goods to Mr. A on credit amounting to $ 5,000. Hence Mr. A becomes the debtor of A Ltd. Also, A Ltd has taken a loan from Mr. A amounting to $ 4,000. Mr. A instructed A Ltd to settle the payment due from him as a debtor against the loan taken by the company. Determine financial liability.
- A financial liability is a liability that results in an outflow of cash or other assets. In the given case, assets as debtors resulted in outflow against the financial liability. Hence the financial liability amounts to $ 4,000 as it is the actual outflow of the asset.
Classification of Financial Liabilities
Financial liabilities can be classified as:
- Short-Term Financial Liabilities: such as creditors, outstanding expenses, and short-term tax liabilities, are termed as those that require an outflow of assets within one year.
- Long-Term Financial Liabilities: It results in an outflow of cash or asset, but outflow is to be made in the long term i.e. liability is to be settled in more than 1 year. Example of long-term liabilities is debentures, deferred tax liabilities, loans, etc.
Financial Liabilities Ratios with Explanation
The various ratios are:
Short-Term Financial Liability Ratio = Short-Term Financial Liabilities / Short-Term Financial Assets
Short-term liabilities include creditors, outstanding payables, short-term loans, etc. In contrast, short-term financial assets include debtors, short-term advances to customers, short-term loans given, cash and equivalents, etc. A short-term financial liability ratio indicates the capability of the organization to pay the liquid liabilities, and it analyses the availability of liquidity in the organization.
Long-Term Financial Liability Ratio = Long-Term Financial Liabilities / Long-Term Financial Assets
Long-term financial liability includes long-term loans, unsecured loans, deferred tax liabilities, debentures, bonds, etc. In contrast, long-term financial assets include long-term investments, loans, advances, etc. Debt Ratio is also an example of financial liability ratio, which is calculated as debt/assets i.e. total liabilities to total assets. The debt ratio gives an idea about the company’s leverage.
Financial Liabilities vs Operating Liabilities
- Financial liabilities are those related to cash-related liabilities, which result in an outflow of cash or other assets. In contrast, Operating liabilities are those related to producing goods and services.
- It may or may not be interest-bearing, whereas operating liabilities are non-interest-bearing.
- It deals with liquidity, whereas operating liabilities deals with the operations of the organization.
- Operating liabilities such as trade payables etc. It can be a financial liability, and sundry creditors are part of operations i.e. Purchase as well as finance which results in an outflow of cash.
Advantages of Financial Liabilities
- Helps to determine the liquidity of the organization.
- Reflect on the financial health and financial condition of the organization.
- Show the organization’s financial solvency, i.e., its ability to pay off its debt.
- It reflects the capability of the organization to pay off its liabilities.
- It helps to improve the financial cycle and helps in efficient and effective working.
Conclusion
Financial liabilities are those liabilities that result in an outflow of cash or other assets. Examples include sundry creditors, outstanding expenses, tax liabilities, loan payments, etc. Further, it can be bifurcated into short-term and long-term financial liability. Short-term take less than 1 year to settle, whereas long-term takes more than 1 year a settlement. It helps to improve the financial position and, thereby, the liquidity ratios.
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