How to calculate liabilities: Step-by-step guide & tips

Published

Dec 5, 2024

Author

A clear-eyed view of your financial position is indispensable for smart decision-making. And while profits and assets are often on the news headlines, debt and expenses are just as critical. Correctly calculating liabilities not only ensures you don’t bite off more than you can chew financially, it also helps you prioritize potential expenditures.

Understanding what qualifies as a liability and how to record it on your balance sheet can feel challenging, even to experts. In this article, we’ll cover where to look for hidden liabilities and review the basic formulas to calculate what your business owes.

What are liabilities?

In financial management, liabilities are obligations, usually money, that businesses owe to third parties, like vendors, lenders, and even employees. You can think of them as payouts the company knows it will need to make but hasn’t yet.

Example: Widget Co. recently took out a small business loan to finance the purchase of a larger workshop. The increased production capacity required that the company hire four additional widget makers. And because Widget Co. owns the workshop, it’s responsible for paying annual city property taxes.

Widget Co.’s accountant records three new liabilities on its balance sheet associated with the workshop: the small business loan payments, payroll for the new employees, and city taxes.

Because liabilities represent a claim against a business’s assets, they’re an essential component of its overall financial health. A company with an extensive portfolio of assets might not be the most attractive investment opportunity, for example, if those assets consume more revenue than they generate.

Example: A private equity firm is debating whether to invest in Widgets.io or CoolApp. As part of the due diligence process, the firm requests a copy of each business’ balance sheet.

CoolApp reported revenue of $10 million for the previous year, plus they purchased an office space in a major city and took out a loan to acquire a competitor. The company balance sheet shows liabilities of $7.5 million.

Widgets.io reported revenue of $6 million but has no liabilities other than employee salaries, which total less than $500,000 annually.

In this case, Widgets.io may be a more attractive investment. Despite its lower revenues, it has a proportionately lower amount of liabilities, and the liabilities do not include any debt which generally reduces financial risk.

Types of Liabilities

Business liabilities fall into three categories depending on the length of the repayment period and the certainty of the obligation.

Short-term liabilities

Sometimes called ‘current liabilities,’ this category includes obligations the business must settle within one year. Examples include accounts payable, taxes, rent, and employee compensation. Many day-to-day operating expenses associated with keeping a business up and running qualify as current liabilities.

Long-term liabilities

Long-term liabilities refer to obligations with repayment periods longer than one year, such as long term loans, bonds payable, deferred tax payments, or mortgages. Typically, companies take on long-term liabilities to finance significant purchases or investments to help the business grow.

Contingent liabilities

While short- and long-term liabilities arise from transactions that have already occurred, contingent liabilities represent potential future obligations that a business might incur under specific circumstances. For example, a company in the middle of a lawsuit might record a possible settlement payout as a contingent liability. It’s not certain that the business will need to pay, but the balance sheet needs to reflect that possibility to give decision-makers the most accurate picture of the company’s financial situation.

Why is calculating liabilities important?

Periodically calculating liabilities is an essential part of managing business finances. Knowing how much you owe can help small businesses stay on top of cash flows and allocate resources effectively. Larger businesses rely on accurate financial information to maintain investor confidence and support strategic decisions around mergers or acquisitions.

Other areas impacted by accurate liability calculations include:

Tax compliance. Many businesses rely on a profit and loss statement to prepare annual tax returns. Accurate liability calculations ensure that the business properly represents the business’s profits and costs.
Creditworthiness. Lenders look closely at a business’ liabilities when determining whether or not to extend a loan or line of credit. Excessive long-term liabilities can increase the risk of default, while high current liabilities might impact size of monthly payments and interest rates.
Profitability. A collection of revenue-generating assets loses some of its luster if those assets come with high liabilities that eat into overall profits.

How to calculate liabilities: 4 steps

The total liabilities formula sums up all your business’ future obligations to give you a big-picture view of all outstanding expenses you’ll need to address in the future. Be aware that the specific total liabilities equation can vary depending on which method you use to calculate long-term liabilities, so it may be worthwhile to check with an accounting professional if you plan to do this yourself.

Step 1. List all liabilities

Start by reviewing your business’s general ledger to identify current obligations. Some of these, like rent payments, compensation, and taxes, are straightforward. Others, like restructuring costs, lease guarantees, litigation, and warranties, aren’t as obvious. You may also need to speak with leaders in other departments to understand potential future expenses, like litigation or acquisitions.

Example: Alex is a financial controller for Acme Corp. and responsible for the company’s annual balance sheet. Before performing any calculations, Alex reviews the general ledger for outstanding amounts payable. Alex also reviews the terms of a new equipment lease agreement and the business loan Acme Corp. took out this year to finance a strategic acquisition.

Alex records the information collected from Acme Corp.’s general ledger in a draft balance sheet:

Step 2. Categorize liabilities as current or long-term

Next, divide the liabilities into current and long-term. Proper classification of liabilities ensures that internal and external stakeholders have a clear, accurate picture of the company’s near-term financial obligations, operational efficiency, risk profile, and financial position. Most accounting standards, such as GAAP and IFRS, also require it.

Example: Alex considers that Acme Corp. will pay its taxes, employees, contractors, and vendors by the end of the calendar year, so Alex categorizes these costs as current liabilities. Because the terms of the business loan require repayment of the principal and interest over ten years, and the equipment lease covers a period of five years, Alex records the future payments as long-term, non-current liabilities.

Acme Corp.’s general counsel informs Alex that there’s a risk that the company may become involved in patent litigation in the coming year. While it’s not yet certain, Alex includes an estimate of litigation costs as a contingent liability. Once Alex is finished, the draft balance sheet looks like this:

Step 3. Calculate total liabilities using software

The process of preparing a balance sheet can require several complex formulas and multiple sets of information. Specialized payroll, and expense management software can help ease the administrative burden and reduce the risk of inaccurate calculations by automating recordkeeping and reporting.

Step 4. Verify your calculations

Financial management software can remove much of the stress and headache associated with preparing a balance sheet. Still, it’s important to double-check the information and documents on which it relies if you want to guarantee compliance. No one knows your business better than your team, and they might spot a slip-up in data entry or reporting that your software doesn’t catch.

Example: While reviewing Acme Corp.’s finalized balance sheet, Alex notices that the amount listed for accounts payable has dropped significantly from the previous quarter. After some investigation, Alex learns that one department did not turn over a quarterly expense report, leading to an inaccuracy in the general ledger.

Formulas for how to calculate total liabilities

You can calculate your business’ total liabilities by adding together all of its short-term and long-term liabilities. You can also calculate total liabilities from the balance sheet by subtracting the owner’s equity from the total assets. You should get the same result no matter which total liability equation you use. That’s because you’re rearranging pieces of the fundamental accounting formula that says a business’ assets are equal to its liabilities plus its owner’s equity.)

Example: Workplace, Inc. records current liabilities of $50,000 and long-term liabilities of $150,000 on its balance sheet.

Current liabilities + Long-term liabilities = Total liabilities

$150,000 + $50,000 = $200,000

Example: Workplace, Inc. records total assets of $500,000 and owner’s equity of $300,000.

Total assets - Owner’s equity = Total liabilities

$500,000 - $300,000 = $200,000

How to calculate current liabilities

To calculate current liabilities, add any and all obligations your business must settle within one year. A typical small business’s liabilities might include:

Accounts payable: Money your business owes for goods and services already received
Notes payable: Written promises to pay a specific amount of money in the future, such as a loan or credit agreement
Accrued expenses: Expenses your business has already incurred but have yet to be paid, like wages, taxes, or interest
Unearned revenue: Payments your business has already received for goods or services you’ve yet to deliver
Short-term debt: Money your business borrowed due within one year

The precise accounting equation you use to calculate your current liabilities will depend on the specifics of your balance sheet, so it’s important to keep comprehensive records and correctly classify your obligations.

Example: Workplace Inc.’s balance sheet shows accounts payable of $50,000, notes payable of $30,000, accrued expenses of $10,000, unearned revenue of $20,000, and short term loans of $15,000.

Accounts payable + Notes payable + Accrued expenses + Unearned revenue + Short term loans = Current liabilities

$50,000 + $30,000 + $10,000 + $20,000 + $15,000 = $125,000

How to calculate long-term liabilities

In simplest terms, calculating long-term liabilities involves summing all outstanding obligations due more than one year in the future. That said, depending on the context and the type of liability, you may use different approaches to account for the differences between, for example, a business loan and an equipment rental.

Balance sheet analysis. Add together all long-term liabilities on your balance sheet. Subtract the portions, if any, due within one year.
Amortized cost. Calculate the present value of future cash payments for loan and bod payments, including interest. Adjust for the amortization of cost adjustments, like discounts and premiums.
Present value. If you’re assessing the risks of a merger, investment or acquisition, you can apply a discount to existing or future obligations using an appropriate interest rate.

Streamline your financial operations with Rippling

While most expense management tools can save you time, they typically aren’t connected with the rest of your company’s finance systems. Rippling consolidates your company’s finances—from payroll and benefits to corporate cards and vendor bills–giving you an up-to-date view of cash flow across your entire company.

Rippling gives you unparalleled control and visibility over company spend. Create customizable reports, approval chains, and policy enforcements—all on one intuitive platform.

With Rippling you can:

Create granular, role-based spending policies and approval chains
Automate otherwise tedious expense management tasks like flagging duplicate or mismatched receipts and syncing transactions to your general ledger
Issue, manage, and revoke corporate cards with customizable spend controls based on employee spending needs

Efficient expense management also means you’re prepared for audits. With expense claims, receipts, and reimbursements neatly organized and recorded, you’ve always got compliant documentation at the ready.

Schedule a demo with Rippling today

See Rippling

How to calculate liabilities FAQs

What are total liabilities?

Total liabilities are the sum of all the short- and long-term debts on your business’s balance sheet. It represents your company’s current and future financial commitments and can impact creditworthiness and profitability calculations.

What is the difference between current and long-term liabilities?

The difference between current and long-term liabilities lies in the payment timeframe. Current liabilities must be settled within one year, while long-term liabilities are due after one year.

Are there tools or software that can help calculate liabilities?

Yes, software solutions that help manage payroll, expense reporting, and invoicing can all help simplify liability calculations. By automating finance tasks, software reduces the opportunity for human error and can increase the accuracy and consistency of important records.

What are common mistakes to avoid when calculating liabilities?

Common mistakes to avoid when calculating liabilities include neglecting to include hidden costs, mismatching reporting periods, and miscalculating interest on loans or credit lines. Relying on inaccurate or out-of-date records can also lead to errors.

How often should liabilities be recalculated?

Business liabilities should be recalculated monthly to ensure accurate records and compliance with accounting standards or tax filing obligations. However, if your business has a high volume of transactions or liabilities that fluctuate frequently, you may need to tally them up more regularly. At a minimum, every business should plan to assess and record its liabilities at the end of each accounting period.

Consolidate and control your spend