Understanding the Components of Current Liabilities
When preparing to analyze a company, one of the first things you'll need to do is to grab a copy of the company's most recent balance sheet. Though it may look like it's written in a foreign language to many new investors, I'll help you decipher the code so that you'll be more confident in your own investment analysis. Let's begin with current liabilities. The current liabilities section of the balance sheet shows the debts a company owes that must be paid within one year. These debts are the opposite of current assets.
Current liabilities include things such as short-term loans from banks including line of credit utilization, accounts payable balances, dividends and interest payable, bond maturity proceeds payable, consumer deposits, and reserves for taxes.
Below are some of the most common and important current liabilities on the balance sheet.
Accounts Payable: The Most Popular Current Liability
Accounts payable is the opposite of accounts receivable. It arises when a company receives a product or service before it pays for it. Accounts payable, or A/P as it is often shorthanded, is one of the largest current liabilities a company will face because they are constantly ordering new products or paying wholesale vendors and suppliers for services or merchandise. Really well-managed companies attempt to keep accounts payable high enough to cover all existing inventory. In effect, this means that the vendors are paying for the company's shelves to remain stocked.
The most effective operators in industries such as discount retailers, Target and Wal-Mart among them, have turned this into an art. In a very real sense, their business growth was funded by vendors such as Procter & Gamble and Clorox, both of which shipped products to the store shelves on credit, giving the merchants a chance to sell the goods before paying the amount owed to these wholesalers. This meant both Wal-Mart and Target could use more of the money they had raised from shareholders, bondholders, and retained profits to fund new store expansion.
This item in the current liabilities section of the balance sheet represents money owed to employees as salaries and bonuses that the company has not yet paid.
Short-Term and Current Long-Term Debt
These current liabilities are sometimes referred to as notes payable. They are the most important item under the current liabilities section of the balance sheet and most of the time, represent the payments on a company's loans or other borrowings that are due in the next twelve months. Using borrowed funds is not necessarily a sign of financial weakness; e.g., an intelligent department store executive may work out short-term loans at Christmas so she can stock up on merchandise before the seasonal rush.
If demand is high, the store would sell all of its inventory, pay back the short-term debt, and pocket the difference. This use of leverage can result in higher returns on equity.
How can you ever hope to tell if a company is wisely borrowing money (such as our illustrative department store), or recklessly going into debt? Look at the amount of notes payable on the balance sheet (if they aren't classified under the notes payable section, combine the company's short-term obligations and long-term current debt). If the amount of cash and cash equivalents is much larger than the notes payable, you shouldn't have any reason to be concerned.
If, on the other hand, the notes payable has a higher value than the cash, short-term investments, and accounts receivable combined, you should be greatly concerned. Unless the company operates in a business wherein inventory can be turned into cash rapidly, this is a serious sign of financial weakness.
Other Current Liabilities on the Balance Sheet
Depending on the company, you will see various other current liabilities listed. Sometimes they will be lumped together under the title "other current liabilities." Normally, you can find a detailed listing of what these "other" liabilities are buried somewhere in the annual report or 10-K. Often, you can figure out the meaning of the entry by its name. If a business lists "Commercial Paper" or "Bonds Payable" as a current liability, you can be fairly confident the amount listed is what will be paid out to the company's bondholders in the short term.
Consumer Deposits Are Liabilities to Banks
If you are looking at the balance sheet of a bank, you will want to pay close attention to an entry under the current liabilities called "Consumer Deposits." In many cases, this will be listed under other current liabilities, if not lumped with them. This is the amount that customers have deposited in the bank. If you're asking why consumer deposits are a liability, the answer is quite simple. Since, theoretically, all of the account holders could withdrawal all of their funds at the same time, the bank must list the deposits as a current liability.