As a small business owner, do you look at your financial statements? Specifically, how about the liabilities and equity side of your balance sheet? It has some important information about the financial health of your business.
A Useful Example
Let's use the following figures of total liabilities and equity taken from the balance sheet of the Hasty Hare Corporation to make a few calculations:
- Accounts payable: $65,000
- Notes payable: $110,000
- Accrued expenses: $15,000
- Current portion of long-term debt: $12,000
- Long-term bonds: $175,000
- Deferred income taxes: $17,000
- Pension liabilities: $65,000
- Preferred stock issued par value: $30,000
- Common stock issued par value: $85,000
- Additional paid-in capital: $25,000
- Retained earnings: $275,000
On the liabilities side of the balance sheet, total liabilities include both short- and long-term debts. Liabilities are monies that the company owes to its various creditors.
What Are Short-Term Liabilities?
Short-term liabilities are monies owed to creditors that are due within one year. Hasty Hare has the following short-term liabilities:
Accounts payable: $65,000. This is the amount owed to suppliers and vendors and is typically due in 30 days. You'd use credit from accounts payable to finance your inventory and accounts receivable.
Notes payable: $110,000. These are promissory notes payable to banks and other lenders that could have maturity dates up to one year. Notes payable could also include a revolving line of credit where the borrower could draw down funds as needed to make up cash flow deficits and repay these advances as funds become available.
Accrued expenses: $15,000. This account includes such items as unpaid accrued wages and accrued interest charges.
Current portion of long-term debt: $12,000. Principal and interest payments from long-term debt obligations that are due within the current year are included in current liabilities.
The total short-term liabilities for Hasty Hare is $202,000.
What Are Long-Term Liabilities?
Debts or other obligations that have maturity dates longer than one year are included in long-term liabilities. The long-term liabilities for Hasty Hare are as follows:
Long-term bonds: $175,000. Hasty Hare used long-term bonds to finance the expansion of its manufacturing plant.
Deferred income taxes: $17,000. Deferred income taxes are usually the result of using different depreciation methods on the company's income tax returns versus its public financial statements.
Pension liabilities: $65,000. Companies with retirement plans for their employees have agreements that require pension payments in the future for retired employees.
Hasty Hare has total long-term liabilities of $257,000.
What's Shareholders Equity?
The owner's equity portion of the balance sheet can include several categories. In our example, Hasty Hare has the following types of owner's equity:
Preferred stock issued par value: $30,000. Unlike common stock, preferred stock usually pays a minimum fixed dividend to its stakeholders.
Common stock issued par value: $85,000. This amount represents the par value of common stock when it's issued.
Additional paid-in capital: $25,000. If the initial issuance of common stock shares brings in more funds than the par value of the stock, the overage is included as additional paid-in capital.
Retained earnings: $275,000. Retained earnings are the accumulated profits the company has retained and not paid out to its shareholders as dividends.
The total owner's equity position of Hasty Hare is $415,000.
What's the Debt-to-Equity Ratio?
Now that you have the calculations for total liabilities and owner's equity, what does this mean? The significance is the debt-to-equity ratio.
One measure of the financial health of a company is its proportion of total debt to owner's equity. A company with a high amount of debt relative to its owner's equity is considered risky. The company's ability to pay its debt obligations during economic downturns and declines in sales could prove difficult. On the other hand, companies with higher equity positions relative to their debt are better able to weather recessions and drops in income.
This ratio is calculated by dividing the sum of short-term notes payable, current maturities of long-term debt and long-term bonds payable by total owner's equity. The debt-to-equity ratio for Hasty Hare is:
($110,000 + $12,000 + $175,000)/$415,000 = 0.72. This is a comfortable, strong financial position.
Keeping an eye on your total liabilities and equity position is an important responsibility for a small business owner. Maintaining a healthy financial condition is necessary for survival and staying competitive in the marketplace.