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Unlock This CourseWhen you look at a balance sheet, you'll see it's split into two main parts. The top shows what a business owns (assets) and the bottom shows how the business paid for those assets. This bottom section contains liabilities and capital - essentially showing who the business owes money to and how much the owners have invested.
Think of it like buying a car. If you buy a £10,000 car with a £6,000 loan and £4,000 of your own money, the car is your asset (£10,000), the loan is your liability (£6,000) and your own money is your capital (£4,000). Businesses work exactly the same way!
Key Definitions:
Liabilities are like IOUs - promises to pay money back. They appear on financial statements because they represent claims against the business. The business must use its assets to pay these debts, so it's crucial to track them carefully. Common examples include bank loans, money owed to suppliers and unpaid bills.
Current liabilities are debts that businesses must pay within the next 12 months. These are like your monthly bills - they need attention quickly and can cause serious problems if ignored.
Understanding different types of current liabilities helps you see how businesses manage their cash flow and short-term financial health.
Money owed to suppliers for goods bought on credit. For example, if a shop buys £5,000 worth of stock and hasn't paid yet, this appears as a trade creditor.
When a business spends more money than it has in its bank account. The bank allows this but charges interest and the business must pay it back quickly.
Bills that have been earned but not yet paid, like electricity used this month but the bill arrives next month. The business still owes this money.
Tesco, the UK's largest supermarket chain, typically has current liabilities of around £8 billion. This includes money owed to suppliers (like Coca-Cola and Unilever), unpaid staff wages and short-term bank borrowings. Managing these efficiently is crucial - if Tesco couldn't pay suppliers, shelves would empty quickly!
Non-current liabilities are debts that don't need to be repaid within the next year. These are like mortgages - big amounts borrowed over several years with regular payments.
Money borrowed from banks to buy expensive assets like buildings or machinery. These loans are typically repaid over 5-25 years with interest. For example, a factory might borrow £2 million to buy new production equipment, paying it back over 10 years.
Long-term borrowing allows businesses to invest in growth without waiting to save up the full amount. It's like getting a mortgage to buy a house rather than saving for 20 years first.
However, long-term debt comes with risks. The business must make regular payments regardless of how well it's performing. If profits fall, these fixed payments can become a serious burden.
Capital represents the owners' stake in the business. It includes money they originally invested plus any profits that have been kept in the business rather than taken out as drawings or dividends.
Capital isn't just the original investment - it grows and shrinks based on the business's performance and the owners' decisions.
The amount of capital at the start of the financial year. This is like your starting point - what the owners had invested at the beginning.
Extra money invested by owners during the year. If business is going well, owners might put in more money to help it grow faster.
Profits kept in the business rather than taken out by owners. This increases the owners' stake automatically as the business succeeds.
Sarah owns a bakery. She started with £20,000 capital. During the year, her business made £15,000 profit, but she took out £8,000 for personal use (drawings). Her closing capital is £27,000 (£20,000 + £15,000 - £8,000). The £7,000 increase shows her business has grown her investment.
The bottom half of a balance sheet shows how assets are financed. It must always equal the top half (total assets) because every pound of assets must be paid for somehow.
Assets = Liabilities + Capital. This fundamental equation means that everything a business owns is either paid for by borrowing (liabilities) or by the owners' money (capital).
If a business buys a £1,000 computer with cash, assets stay the same (lose £1,000 cash, gain £1,000 computer). If bought with a loan, assets increase by £1,000 and liabilities increase by £1,000. The equation always balances because every transaction affects both sides equally.
The mix of liabilities and capital tells you a lot about a business's financial health and strategy. Too much debt can be dangerous, but some debt can help a business grow faster.
Financial analysts look at several key measures to understand how well a business manages its liabilities and capital.
Current Ratio: Current Assets ÷ Current Liabilities. This shows if a business can pay its short-term debts. A ratio above 1 means it probably can; below 1 suggests potential cash flow problems.
Gearing Ratio: This compares debt to capital, showing how much the business relies on borrowing versus owners' money. High gearing means high risk but potentially high returns.
Pizza Express, a UK restaurant chain, faced difficulties when it had high levels of debt (around £1.1 billion) but declining profits. The fixed loan payments became hard to meet when fewer customers visited during economic uncertainty. This shows why the balance between debt and capital matters - too much debt can sink a business when times get tough.
Understanding liabilities and capital helps you make better business decisions, whether you're running a small business, investing in shares, or just trying to understand how successful companies operate.
Knowing your liability and capital structure helps you plan for the future. If you have lots of current liabilities, you need to ensure good cash flow. If you're considering expansion, you'll need to decide between borrowing money (increasing liabilities) or finding investors (increasing capital).
For investors, these figures show how risky a business might be and how much room it has to grow. A business with little debt might be safe but could be missing growth opportunities. One with lots of debt might offer high returns but carries more risk.
Always remember that liabilities and capital must equal assets. If you're preparing financial statements and they don't balance, you've made an error somewhere. This fundamental rule helps you check your work and understand business finances better.