Current Liabilities, Contingent Liabilities, Financing with Debt vs. Equity
Explain & Account for Current Liabilities
What are Current Liabilities?
Current liabilities are obligations due within 1 year, or within the company’s normal operating cycle if it’s longer than a year. Obligations due beyond that are long-term or non-current liabilities.
2 Kinds of Current Liabilities
- Known Amounts
- Estimated Amounts
What are Current Liabilities of Known Amounts?
- Short-Term Borrowings: Companies sometimes need to borrow money on a short-term basis. A line of credit allows a company to access credit on an as-needed basis up to a maximum amount set by the lender.
- Accounts Payable: Amounts owed for products or services purchased on credit are accounts payable.
- Accrued Liabilities (or Accrued Expenses): An accrued liability results from an expense the business has incurred but has not yet been billed for or paid. Because accrued liabilities often arise from expenses, they are sometimes called accrued expenses. Common Types of Accrued Liabilities:
- Salaries & Wages Payable.
- Interest Payable.
- Income Taxes Payable.
- Short-Term Notes Payable: Short-term notes payable are notes payable due within 1 year.
What are Current Liabilities That Must Be Estimated?
A business may know that it has a present obligation & that it’s probable it will have to settle this obligation in the future, but it may be uncertain of the timing or amount of the liability. Despite this uncertainty, IFRS require the business to estimate & record a provision for this obligation in its financial statements. A provision is a specific type of contingent liability.
Estimated liabilities vary among companies & include warranties, employee pension obligations, & corporate restructuring costs.
Estimated Warrant Payable
Many companies guarantee their products under warranty agreements that cover some period after purchase. Sale of a product with a warranty attached is a past event that creates a present obligation, which will require company resources (repair or replacement) to settle in the future. At the time of the sale, however, the company doesn’t know which products will be defective or how much it will cost to fix/replace them. Business must estimate warranty expense & the related warranty liability.
Suppose a company sold 4,000 tools subject to 1-year warranties. If, in past years, between 2-4% of products proved defective & cost an average of $50 to replace each tool, the company could estimate that 3% of the products it sells this year will require repair/replacement. The company would estimate warranty expense of $6,000 (4,000 x 0.03 x $50) for the period & make this entry:
If the company ends up replacing 100 defective tools costing $4,800, it would record the following:
At the end of the year, the company reports Estimated Warranty Payable of $1200 as a current liability. The income statement reports Warranty Expense of $6,000 for the year. Next, year the process repeats.
What are Contingent Liabilities?
Contingent liabilities are possible obligations that will become actual obligations only if some uncertain future event occurs. They also include present obligations for which there is doubt about the need for the eventual outflow of resources to settle the obligation, or for which the amount of the obligation cannot be reliably estimated. Lawsuits in progress, debt guarantees, & audits by the Canada Revenue Agency are examples of contingent liabilities.
Under ASPE, contingent liabilities that are likely to occur and can be reasonably estimated are accrued as liabilities. Other less-certain contingent liabilities, under both IFRS and ASPE, are simply disclosed in the notes. Even note disclosure is not required if there is only a remote chance the contingent liability will occur.
Are All Liabilities Reported on the Balance Sheet or Disclosed in Notes?
Not reporting a liability means a company would understate liabilities & likely overstate net income.
Financing with Debt vs Equity
3 Main Ways to Finance Business Activities
- Excess Cash: A company must have saved enough cash & short-term investments from past prof so that it can self-finance its desired business activities. This is a low-risk & low-cost option.
- Issuing New Shares: This creates no new liabilities & requires no interest payments, so it does not increase a company’s credit risk. Dividends are usually optional, so they can be avoided if cash flows are poor or the company has other needs for its cash. Issuing shares, however, can cost a lot in legal & other financing fees, and can also dilute the control & earnings per share of existing shareholders.
- Borrowing Money: This can be somewhat costly in terms of financing fees paid to arrange the debt. Taking on more debt can increase a company’s credit risk, and it requires regular principal & interest payments, which cannot be postponed when cash flows are poor.
What is Earnings Per Share (EPS)?
EPS represents the amount of net income (or loss) earned by each of a company’s outstanding common shares. It’s useful for evaluating earnings performance of a company & assessing the impact of various financing options on earnings. Example:
Decision Guidelines for Financing with Debt or Equity
Suppose you are the owner of El Taco, who wants to expand into central Canada.
Analyze & Evaluate a Company’s Debt Paying Ability
What is the Accounts Payable Turnover (T/O)?
T/O measures the number of times a year a company can pay its accounts payable.
The average accounts payable amount is calculated using the year’s opening and closing balances. Once the turnover is computed, it is usually expressed in number of days, or days payable outstanding (DPO), by dividing the turnover into 365.
Generally, a high turnover ratio (short period in days) is better than a low turnover ratio. However, some companies with strong credit ratings strategically follow shrewd cash management policies, withholding payment to suppliers as long as possible, while speeding up collections, in order to conserve cash (like Walmart).
What is the Leverage Ratio?
This ratio shows a company’s total assets per dollar of shareholders’ equity. A leverage ratio of exactly 1.0 would mean a company has no debt, because total assets would exactly equal total shareholders’ equity.
The higher the ratio, the more it magnifies return on shareholders’ equity (Net Income/Average Shareholders’ Equity, or ROE). If net income is positive, return on assets (ROA) is positive. Leverage ratio magnifies this positive return to make return on equity (ROE) even more positive. This is because the company is using borrowed money to earn a profit (known as trading on the equity). However, if earnings are negative (losses), ROA is negative, & leverage ratio makes ROE even more negative.
What is the Times-Interest-Earned Ratio?
This ratio measures the number of times a company’s operating income can cover interest expense. The ratio is also called the interest-coverage ratio. A high times-interest-earned ratio indicates ease in paying interest expense; a low value suggests difficulty.