Lesson 23 - Beginner accounting course

23. Short-Term vs. Long-Term Liabilities: Key Differences

Liabilities are financial obligations that a company must settle over time. They can be categorized into short-term (current) liabilities and long-term (non-current) liabilities based on their due dates. Understanding the differences between these two types of liabilities is crucial for financial planning, liquidity management, and business decision-making.

Definition of Short-Term and Long-Term Liabilities

• Short-term liabilities (current liabilities) are obligations that must be settled within one year or within the company’s operating cycle, whichever is longer.

• Long-term liabilities (non-current liabilities) are obligations that extend beyond one year and often involve structured repayment schedules.

Key Differences Between Short-Term and Long-Term Liabilities

Short-Term Liabilities: Characteristics and Examples

Short-term liabilities are primarily related to day-to-day operations. Businesses must ensure they have enough current assets (such as cash and receivables) to meet these obligations when they become due.

Examples of Short-Term Liabilities

1. Accounts Payable – Amounts owed to suppliers for goods and services received but not yet paid for.

2. Short-Term Loans – Loans taken from banks or financial institutions that must be repaid within a year.

3. Wages and Salaries Payable – Compensation owed to employees for work performed.

4. Taxes Payable – Income tax, payroll tax, or sales tax owed to the government.

5. Interest Payable – Interest on loans or bonds due within a year.

6. Unearned Revenue – Payments received in advance for services or products not yet delivered.

Example: If a company buys $5,000 worth of raw materials on credit, it records:

• Debit: Inventory (Asset) $5,000

• Credit: Accounts Payable (Liability) $5,000

When payment is made:

• Debit: Accounts Payable $5,000

• Credit: Cash $5,000

Long-Term Liabilities: Characteristics and Examples

Long-term liabilities are used to finance significant business activities, such as purchasing fixed assets, acquiring companies, or funding large projects. These obligations are not due immediately, which allows businesses to spread payments over time.

Examples of Long-Term Liabilities

1. Long-Term Loans and Bonds Payable – Borrowings from banks or investors that must be repaid over several years.

2. Deferred Tax Liabilities – Taxes owed but deferred to a future period due to accounting differences.

3. Pension and Retirement Obligations – Future payments to employees for pension benefits.

4. Lease Liabilities – Long-term lease agreements for property or equipment.

5. Mortgage Payable – Loans secured by real estate, typically repaid over many years.

Example: If a company takes a $100,000 loan for 5 years, the journal entry upon receiving the loan is:

• Debit: Cash $100,000

• Credit: Loan Payable (Non-Current Liability) $100,000

Each year, when repaying a portion:

• Debit: Loan Payable $20,000

• Credit: Cash $20,000

How Businesses Manage These Liabilities

Managing Short-Term Liabilities

• Maintain Sufficient Cash Flow – Ensure cash reserves or liquid assets can cover short-term obligations.

• Use Credit Wisely – Avoid excessive short-term borrowing to prevent liquidity issues.

• Monitor Payment Schedules – Pay accounts payable on time to avoid late fees and maintain supplier relationships.

Managing Long-Term Liabilities

• Plan Debt Repayment – Structure payments to align with expected revenue growth.

• Leverage Long-Term Financing for Growth – Invest in assets that generate revenue over time.

• Maintain a Good Credit Rating – Helps secure lower interest rates on future borrowings.

Why Understanding These Liabilities is Important

1. For Investors and Creditors – Helps assess a company’s ability to meet obligations.

2. For Business Owners and Managers – Ensures proper financial planning and risk management.

3. For Accountants and Analysts – Provides insights into financial stability and funding strategies.

Final Thoughts

Both short-term and long-term liabilities play crucial roles in a company’s financial structure. Short-term liabilities affect liquidity and working capital, while long-term liabilities impact financial stability and strategic growth. A balanced approach to managing both ensures that a business remains solvent and financially healthy.