A liability is a debt. It is something that you owe; something for which you are liable. You received the benefit today, but have not yet paid for it. You must pay at some point in the future. How far into the future? It depends. Liabilities can be divided into two categories: current liabilities and long-term liabilities. Current liabilities are those amounts that must be paid within short period of time, typically a year. Long-term liabilities are those that have a longer time before payment is due.
The balance on your credit card is an example of a current liability. So is a bank loan you may have taken out that must be paid in full within a period of a year. Or perhaps you purchased a new 60-inch smart TV at an appliance store that was offering “Twelve months, same as cash.” Property taxes and insurance payments are other examples of current liabilities since these also must be paid within the time frame of a year. On the other hand, the mortgage on your home is an example of a long-term liability, as is that 5-year loan that you took out to buy a new vehicle—unless, of course, you will be making the final payment on either of those loans in the current year.
We incur liabilities to purchase assets. For example, you might use your credit card to purchase food, gasoline for your car, or a nice piece of jewelry. You now have use of those items, but you haven’t yet paid cash for them. And, as alluded to above, people typically need to get a mortgage to help with the purchase of a house. A lot of people also use loans to finance the purchase of a vehicle. A good rule of thumb is to try to match the term of the debt you are incurring to the life of the asset. For example, using a credit card for food and gasoline purchases makes sense, but it wouldn’t be wise to use a credit card to purchase a new vehicle, even if you have enough credit available on your card to do so. Unless you pay the balance in full at the end of the month, you are going to be racking up a lot in interest expense. A 5-year car loan makes a lot more sense since five years better matches the length of time you will probably own that car. The standard mortgage term is 30 years because homes tend to have long expected lives—even if you don’t plan on living in the one you are currently buying for that long.
Rather than purchasing assets outright, people can utilize liabilities to increase their assets in other ways. To illustrate, consider Myra, who decides to augment her family’s income by becoming an Uber driver. She purchases a car, using a car loan with a required monthly payment of $300. Gas and car maintenance fees amount to $200 a month and are paid for with a credit card. This makes total monthly liabilities associated with the Uber job $500. However, Myra earns $800 in after-tax income each month by being a driver. After she uses this to pay off her $500 in liabilities, her cash account, an asset, increases by $300 a month.
Once you pay off your liabilities, you will own your assets free and clear, which increases your net worth. Net worth is an important number that lenders consider when you apply for a new loan. You can calculate your net worth at any point in time by subtracting your liabilities from your assets:
Net worth = total assets – total liabilities
If you look at the balance sheet of a typical company, you will find short-term bank loans (usually referred to as “notes payable”), insurance payable, taxes payable, and accounts payable listed under “Current liabilities.” Accounts payable refers to goods and/or services the company has purchased from its suppliers, but for which it has not yet paid the suppliers. For example, a restaurant might order 20 cases of wine from its supplier at a cost of $2,400. Until the restaurant pays its supplier, the $2,400 will be an account payable—i.e., still to be paid. Long-term liabilities of a typical company include long-term bank loans and mortgages or long-term leases.
The liabilities of both individuals and businesses represent amounts that must be paid at some point in the future. The only real differences lie in the terminology used and the fact that individuals aren’t going to have “accounts payable.” The same equation applies when calculating the net worth of a company: Net worth = total assets – total liabilities. The net worth of a company is often referred to as “equity.”