Concept Title: Liabilities on the balance sheet
Description: Continues the discussion of basic accounting and finance terms with a focus on liabilities on the balance sheet
The opposite of assets, liabilities are things that other people own and the firm owes. Similar to assets there are also different shades of liabilities. The distinction between different classes is based on the average time the liability will be outstanding.
i. Current Liabilities
Current liabilities have a life span less than the operating cycle of a firm. The most common types of current liabilities that you will see on a balance sheet are as follows:
Lines of credit / overdraft facilities at banks
This is an arrangement with the firm’s bank that allows the firm to borrow money within certain limits without any significant processing at the bank’s end. For example assume that for some reason the actual cash in bank in not enough to cover payroll. If the firm has an over draft facility at the bank it can use that to draw cash and pay salaries. The result is that the firm now has a negative bank balance. However these are short terms loans and generally last less than a month. Unless specified otherwise, we expect that as the firm’s cash situation improves, the bank account will once again turn positive. The primary objective of these facilities is to cover seasonal or short-term cash or liquidity squeezes.
Short term loans and debt
Another option that larger firms use is short to medium term working capital loans. These are loans that remain outstanding for as long as nine months to a year. There are a number of businesses that need financing to manufacture products and then provide supplier credit so that the same products can be sold to their final user. All of this requires cash, which as we know is a scarce resource. Firms first use these loans to build up inventory, then build up receivables and finally use the cash generated from receivables to payoff the loan. There are a number of sources for these loans and they would be covered in more detail in later sections
The most common term used in transactions between businesses is credit. Firms buy products on credit and sell products on credit. On the supplier side it builds up receivables and on the buyer side it builds up payables. Accounts payables refer to the amount that the firm owes its suppliers and vendors for the use of goods and services. Depending on credit terms, cash situations and management effectiveness, accounts payable can have a life anywhere from 15 to 90 days (sometime even more)
Accrued benefits & obligations
When you think about it, an additional group of people that extends credit to the firm is its employees. They work in advance for wages and the firm pays them a week, fortnight or even a month later. At the end of a financial period it is possible that employees have worked for a portion of their working period and have not been paid. Similarly interest on loans and debt may have accrued for the partial period but would not be due till the next payment date. Accrued benefits & obligations refer to obligations that have been “earned” but would not be due till a date in the future.
Current portion of long-term debt
In certain cases, besides interest payments, every year, we must also retire a percentage of the outstanding amount of the original loan. We call the amount of retired principal the current portion of long-term debt. Since the life of the current portion is less than one year, we include it with current liabilities
ii. Long Term Liabilities
Any liability lasting longer than one year is classified as long term liability. Average life is between 3 – 5 years but can be longer than five years. Debt is one form but there are other variations also. For instance, firms generally make long term promises to employees about retirement and health benefits. These obligations have an average maturity that runs beyond 10 years. Other examples of long term liabilities on the balance sheet include long-term performance bonds, contractual obligations, legal liabilities & reserves.
1) Meals on Wheels purchases a new van to help with deliveries. What category will this be mentioned under on the Balance Sheet?
- Current Assets
- Fixed Assets
- Current Liabilities
- Long-term Debts
2) Mr. Liu is short $1000 of the amount he needs to pay his employees. He decides to borrow the amount from his brother on no interest, promising to pay him back next month. In what part of his balance sheet will Mr. Liu mention this amount?
- Current Asset
- Fixed Asset
- Current Liability
- Long-term Debt
Concept Title: Net working capital
Description: Explains Net Working Capital and how to calculate it
What is Net Working Capital?
We can easily calculated Net Working Capital by subtracting current liabilities from current assets. One explanation of net working capital is that it represents the total capital tied up during the operating cycle of the firm. Remember the operating cycle starts from purchasing followed by production, distribution and collection in that order.
What happens in purchasing cycle? We buy material and input on credit from suppliers. What happens in production cycle? We combine effort, labor, resources and our purchases to manufacture our products. Some of these expenses are incurred in cash, while others are on credit. In distribution we sell our products to our distributors, customers and end users on credit. Before distribution happens, our finished goods wait in warehouses to be picked up by distributors. Finally in collection we collect what is owed to us. Throughout the operating cycle, the firm and its associates invest capital in in the firm.
Negative or Positive?
A positive net working capital indicates that the firm has to make a net investment in its operating cycle. This means that the firm has to increase (read: buy, invest, purchase, spend money) its assets to support current and future volumes of sales. What are these assets? They are cash, accounts receivables and inventory – or current assets. The investment is temporary. The firm will pay it back as their operational cycle ends.
Suppliers and employees often fund this increase since they sell products and services to the firm on credit. These liabilities are current liabilities. Generally the incremental (additional) investment in current assets is greater than the funds provided by the increase in current liabilities and we have positive net working capital.
Negative net working capital is the opposite situation. This indicates that the credit provided by external parties (suppliers, customers, distributors, etc) is more than enough to support the additional investment in current assets required to generate sales.
1) Marian Davis has the following assets and liabilities
Furniture $ 2000
Cash in Bank $ 2500
Vehicles $ 15000
Cash in Hand $ 500
Short-term Debt $ 750
Loan for Car $ 6000
(to be paid over a period of 3 years)
What is the Net Working Capital?