Welcome to the fifth and final article in our Balance Sheet Interpretation series.
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So far in our series, we have reviewed balance sheet basics, how to use liquidity ratios to avoid a liquidity crisis, how to use the price-to-book ratio, and how to interpret current assets.
Now, let's move on to current liabilities.
Liabilities are divided into two major categories: current and long-term. Current liabilities are expected to be settled within one year or one business cycle. All liabilities that are not current liabilities are considered long-term liabilities.
The five main categories of current liabilities are: accounts payable, accrued expense, income tax payable, short-term notes payable, and current portion of long-term payable. Let's take a look at each category.
Accounts payable entries represent how much goods and services the company purchased from suppliers but have not yet paid. Think of this as a company's credit card balance: it is a short-term debt that must be repaid. If the company has trouble paying off these debts, sometimes creditors will give it more time to pay it off. When this occurs, there will be a short-term increase in current assets. Pay attention to see if accounts payable is larger than usual.
Accrued expenses are expenses that have been incurred but have not been paid for. Although these are commonly viewed as current liabilities, this is not always true. Examples of accrued expenses are wages, taxes, and interests.
Businesses accrue expenses for budgeting purposes. For example, an insurance policy payment, usually an accrued expense, might be paid once in a lump sum every year. That expense needs to be accrued over time to accurately reflect spending. Many small businesses do not use accrual accounting and, as a result, fail to budget for large expense payments.
Income tax payable
Perhaps the most dreaded accrued expense is income tax payable. These are taxes that a business will have to pay to the government within one year.Because business taxes are so centrally involved in business profitability analysis, Income Tax Payable is a current liability that always gets a separate line in the balance sheet.
Short-term notes payable
Short-term notes payable are, as the name implies, money that the business has borrowed that must be repaid within a year. All long-term debt, except for perpetual bonds, must be paid off sooner or later. In other words, all long-term debt will, sooner or later, become classified as current liabilities (to be paid within a year).
Current portion of long-term debt
When long-term debts are due within a year, they are moved to the "current portion of long-term debt" section. When you are analyzing a balance sheet, pay close attention to long-term debt since not all long-term debt are so long-term. Make sure that the company has enough cash to support its debt obligations.
Learn More About Interpreting a Balance Sheet
To learn how to read a balance sheet and understand what a balance sheet says about how a company is doing, read the other articles in the Balance Sheet Interpretation Series: