Definition of Financial Liabilities
Financial liabilities are contractual obligations in which there is an outflow of any financial asset including cash to another entity as a result of a past transaction or maybe there is an exchange of financial assets or the financial liabilities with some other entity where the conditions are potentially unfavourable for the entity.
Explanation
The financial liabilities can be the following any of the following items:
- Any contractual obligation that results in the outflow of cash or some other financial asset to some other entity or exchange of financial assets or liabilities in potentially unfavourable conditions.
- Any contract that may be settled in the equity that belonged to that entity and when it is a non-derivative then the business entity may be or is obliged to do the delivery of its own equity instruments that are variable in number and when it is derivative then the business entity will or may settle the same probably not by cash or similar asset but by its own equity instruments that are fixed in nature.
Example of Financial Liabilities
- An Ltd. purchased goods from a dealer on credit for $ 5,000, which is shown as creditors in current liabilities after 1 month an Ltd. has to pay $ 5,000 to the dealer. So, payment to creditor i.e. dealer c becomes the financial liability as to payment to creditor results in an outflow of the asset i.e. cash.
- A purchased some items from a shopping mall and paid through credit card. at the end of every month, the bill of credit card is generated and to be paid by the 10th of the next month. So, credit card payment becomes the financial liability for Mrs A as it results in an outflow of asset which is cash.
- A company has to pay rent for occupying the office building to the owner of building hence the rent is classified as current or short-term liabilities which resulted in the payment of cash. So rent is an example of financial liability.
- B incorporation took a loan from ABC bank which is to be repaid in 5 years in equal monthly instalments, as repayment of loan involves the outflow of cash i.e. Financial asset hence loan from ABC bank is treated as a financial liability and as loan involves the interest component hence the loan and took more than 1 year in settlement of liability hence Loan from ABC Bank is long term financial liability.
- An Ltd sold goods to Mr A on credit amounting to $ 5,000, hence Mr A becomes the debtor of A Ltd. Also, A Ltd has taken a loan from Mr A amounting to $ 4,000. Mr A instructed A Ltd to settle the payment due from him as debtor against the loan taken by the company. determine financial liability?
- A financial liability is a liability which resulted in an outflow of cash or other assets. in the given case asset as debtors resulted in outflow against the financial liability. Hence the financial liability is amounting to $ 4,000 as it is the actual outflow of the asset.
Classification of Financial Liabilities
The financial liabilities can be classified into the following categories:
Financial liabilities can be classified as short-term financial liabilities and long-term financial liabilities:
- Short-Term Financial Liabilities: Those Financial Liabilities which results in an outflow of asset and outflow is to be made within 1 year is termed as short-term financial liabilities and examples are creditors, outstanding expenses, short-term tax liabilities etc.
- Long-Term Financial Liabilities: Long-term financial liabilities are those liabilities which results in an outflow of cash or asset but outflow is to be made in long term i.e. liability is to be settled in more than 1 year. Example of long-term liabilities is debentures, deferred tax liabilities, loans etc.
Financial Liabilities Ratios with Explanation
The various ratios related to financial liabilities are:
Short-Term Financial Liability Ratio = Short Term Financial Liabilities / Short Term Financial Assets
Short term liabilities include creditors, outstanding payables, short term loans etc. whereas short term financial assets include debtors, short term advances to customers, short term loans given, cash and equivalents etc. A short term financial liability ratio indicates the capability of the organization to pay the liquid liabilities and it analyses the availability of liquidity in the organization.
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Long-Term Financial Liability Ratio = Long Term Financial Liabilities / Long Term Financial Assets
Long term financial liabilities include long term loans, unsecured loans, deferred tax liabilities, debentures, bonds etc. whereas long term financial asset includes long term investment, long term loans and advances given etc. Debt Ratio is also an example of financial liabilities ratio which is calculated as debt/assets i.e. total liabilities to total assets. Debt ratio gives an idea about the company’s leverage.
Financial Liabilities vs Operating Liabilities
- Financial liabilities are those liabilities which are related to cash related liabilities which result in an outflow of cash or other assets whereas Operating liabilities are those liabilities which are related to the production of goods and services.
- Financial liabilities may or may not be interest-bearing whereas operating liabilities are non-interest-bearing liabilities.
- Financial Liabilities deals with liquidity whereas operating liabilities deals with operations of the organization.
- Operating liabilities such as trade payables etc. Can be financial liabilities as well as sundry creditors are part of operations i.e. Purchase as well as finance which results in an outflow of cash.
Advantages of Financial Liabilities
Advantages of financial liabilities are as under:
- Helps to determine the liquidity of the organization.
- Financial liabilities reflect financial health and financial condition of the organization.
- Financial liabilities show the financial solvency of the organization i.e. its ability to pay off the financial debt.
- It reflects the capability of the organization to pay off its liabilities.
- It helps to improve the financial cycle and helps in efficient and effective working.
Conclusion
Financial liabilities are those liabilities which results in an outflow of cash or other assets the common examples of financial liabilities include sundry creditors, outstanding expenses, tax liabilities, loan payments etc. Further, the financial liabilities can be bifurcated into short term financial liabilities as well as long term financial liabilities. Short term financial liabilities take less than 1 year for settlement whereas long term financial liabilities take more than 1 year in a settlement. Financial liabilities help to improve the financial position and thereby the liquidity ratios.
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