Liabilities in a business arises due to owing funds to parties outside the company. This is a legal obligation the company is bound to fulfil in the future. Liabilities arise from the debt taken, and the nature of debt is dependent on the requirement for taking it. Thus, they may be short term or long term. The key difference between current and long term liabilities is that while current liabilities are the liabilities due within the prevailing financial year, long term liabilities are liabilities that take longer than one financial year to be settled.
CONTENTS
1. Overview and Key Difference
2. What are Current Liabilities
3. What are Long Term Liabilities
4. Side by Side Comparison – Current vs Long Term Liabilities
5. Summary
What are Current Liabilities
Current Liabilities are short-term financial obligations whose settlement is due within the accounting period, most commonly one year.
Types of Current Liabilities
Accounts Payable
This is the funds receivable by company creditors. Accounts payable arises due to credit sales.
Accrued Expenses
An accounting expense recognized in the books before it is paid for (e.g. accrued rent).
Interest Payable
If a company has long term borrowings, periodic interest should be paid.
Short-term Debt
Any type of debt taken that the due date falls within the course of the accounting year (e.g. short-term bank loan).
Bank Overdraft
An allowance granted by the bank for the company to write checks to an amount exceeding the bank account balance. This is allowed for the trusted customers.
Current liabilities are a vital aspect in determining the liquidity position and,two important ratios are calculated using the current liabilities.
1. Current Ratio
Current Ratio is also called the ‘working capital ratio’ and calculates the company’s ability to pay off its short-term liabilities with its current assets. It is calculated as,
Current Ratio = Current Assets/Current Liabilities
Ideal current ratio is considered to be 2:1, meaning there are 2 assets to cover each liability. However, this can vary depending on the industry standards and company operations.
Acid Test Ratio
Acid test ratio is also referred to as the ‘quick ratio’ and is quite similar to the current ratio. However, it excludes inventory in its calculation of liquidity. The reason for this is that inventory is generally a less liquid current asset compared to others. It is calculated as,
Acid Test Ratio = (Current Assets – Inventory) / Current Liabilities
The above ratio provides a better indication of the liquidity position compared to the current ratio, and the ideal ratio is said to be 1:1. However, same as with the current ratio, the accuracy of this ideal is considered to be questioned by financial experts.
What are Long Term Liabilities?
These refer to long-term financial obligations that do not mature within the accounting period (one year). For most type of long term liabilities, collateral (a real asset that the borrower pledges as security, like real estate or savings) is needed to obtain debt. This is to safeguard the interests of the party providing the debt since the asset can be sold to cover the funds in case the borrower defaults payment.
Types of Long Term Liabilities
Long Term Loans
Debt payable over an extended time frame that exceeds one year.
Capital Lease
A loan agreement to obtain a non-current asset. Some capital leases can extend to a significantly long period, the maximum being 99 years.
Bonds Payable
A financial security that contains a face value and a maturity date issued to obtain finance from investors.
Figure 1: Bonds are issued by both governments and corporates to fund investing requirements
An important aspect regarding long term liabilities is that they also contain an element of short-term liability, most commonly in the form of annual interest. Thus, the interest payable for each year has to be recorded as a current liability while the outstanding capital amount should be shown under long term liabilities.
What is the difference between Current and Long Term Liabilities?
Current vs Long Term Liabilities |
|
| Current Liabilities are liabilities that are due within the prevailing financial year. | Long Term Liabilities are liabilities that take longer than one financial year to be settled. |
| Examples | |
| Accrued expenses, accounts payable and interest payable are common examples of current liabilities. | Long term loans, bond payables and capital leases are types of long term liabilities. |
| Relationship with Assets | |
| Current assets should be sufficient to offset current liabilities. | Long term assets should be sufficient to offset long term liabilities. |
Summary – Current vs Long Term Liabilities
The decision as to whether short term or long term debt should be considered depends on the nature of the business requirement. For example, if the company plans to construct a new building then applying for a short term debt is not practical. Long-term investments should be financed through long term debt, and short term investments should be financed through short-term debt. Thus, the difference between current and long term liabilities preliminarily result from the time period within which the debt will be settled and the nature of the requirement that funds are been borrowed.
Reference:
1. “Liabilities.” Liabilities | Types | Classifications | Explanation | Examples. N.p., n.d. Web. 22 Feb. 2017.
2. “What is a long-term liability? | AccountingCoach.” AccountingCoach.com. N.p., n.d. Web. 22 Feb. 2017.
3. “Current Vs. Long-Term Liabilities.” Chron.com. N.p., n.d. Web. 23 Feb. 2017.
4. “The difference between current ratio and quick ratio – Questions & Answers.” Accounting CPE & Books – AccountingTools. N.p., n.d. Web. 23 Feb. 2017.
Image Courtesy:
1. “Greece gmnt bonds”By Verbal.noun at English Wikipedia (CC BY 3.0) via Commons Wikimedia