More Balance-Sheet Basics: Liabilities and Net Worth
Originally published: 03.01.11 by Ruth King
Taking a monthly ‘snapshot’ is vital for business viability.
Liabilities are debts that your business owes. Like assets, liabilities are divided into two segments: current liabilities and long-term liabilities.
Current liabilities are debts that must be paid within one year. The major categories of current liabilities are accounts payable, accrued taxes, deferred income, warranty, and current portion of longterm debt.
There are three types of accounts payable. The first is trade payables or suppliers your cmpany owes money too. The second is employee payables used when an employee loans money to the company. The third is owner payables used when an owner loans the company money.
If you expect the company to pay a loan back within a year, the loan amount goes into current liabilities. If you don’t expect the company to repay the loan to the owner in a year, the loan amount goes in long-term liabilities. The next major category of current liabilities is accrued taxes.
Generally these taxes are payroll taxes, federal and sometimes state income taxes, sales taxes, franchise taxes, and a number of local taxes. These are all due within one year and usually a lot sooner than that. Please verify that payroll taxes are current.
Owners of the business are personally liable for payroll tax payments. Make sure that you see the payment confirmation numbers. Interest and penalties on these taxes are expensive!
The next current liabilities category is deferred income. There are two types of deferred income: service agreements, and deposits (different from asset deposits). Let’s cover service agreements first.
When your company sells residential service agreements, the customer pays for the agreement in advance. Let’s say your agreement cost to the customer is $100. When Mrs. Jones pays you that $100, she is trusting that your company will perform its obligations that year.
An obligation is a debt. The company’s liability or debt is to perform one (two or three, depending on your agreement) maintenance checks per year. This is the contract with Mrs. Jones. When the company performs the first maintenance check, if the agreement calls for two maintenance checks per year, the company decreases half of the liability since it has performed half the work. The decreased liability is due to performing the work and as such, when the work is performed, this increases service agreement revenues on the income statement.
Assuming that there are two checks per year, the company now has $50 in revenues and $50 in deferred income. When the company performs the second check, the entire liability is gone , and the entire $100 can then be counted as service agreement revenues. If, during the agreement year, Mrs. Jones wants her money back, the company is obliged to return the unused portion of the agreement. When you sell a service agreement a year in advance, the cash that is received should go into an interest-bearing account. This is what I call “the rainy-day fund.” You can take the cash out of the rainy-day fund as you do the work. However, most contractors leave it in there until they need it for that rainy day.
This is the proper way to account for service agreement sales. When you review your financial statements at the end of the month, you always know how much liability you have in terms of the work that needs to be performed. The other type of deferred income is deposits. I know of a lot of contractors who get deposits for future work. Here’s an example:
A contractor in the northern United States sells air conditioning equipment replacements in the winter with the intention of performing that work in the spring after the snow has melted. His reasoning to the customer is that the customer can lock in this year’s price and have the work performed the following spring. He explains that the manufacturers usually raise their prices in January, and his price will then have to increase to cover his increasing costs.
Many customers agree to lock in the price at the lower price in the winter for work to be done in the spring with a 10% deposit. The deposit is fully refundable. That 10% deposit was given to the company for future work. The company now has a liability to perform that work. This is deferred income. When the work gets performed, the liability goes away and the contractor has revenue. Again, very similar to the service agreements, the company has a liability until it performs the work. So, customer deposits for future work are current liabilities until the work is performed.
The next major category of current liabilities is warranty. This account can become substantial for those contractors who do a lot of residential or commercial construction. As a condition for most construction jobs, the contractor has to warranty the work for a year. Therefore, each job cost includes warranty expense. Since the company hasn’t performed the warranty at the conclusion of the job, this obligation is recorded in current liabilities under the warranty category. It becomes liability to your company until the warranty period is up.
At the end of the warranty period, any unused expense is considered additional profit to the job. If your company had a warranty issue, the expense for taking care of that issue comes out of the warranty fund. That’s why it’s there. Hopefully, at the end of the year, there were enough funds to take care of any warranty issues.
The next major current liabilities category is current portion of long-term debt. Let’s use the example where a company purchases a truck and takes out a loan for three years to pay for the truck. Of the three-year period, one year’s principal repayment is due within a year. This is the current portion of long-term debt. The other two years go into longterm liabilities. Once 12 months payments have been made, there is one year in long-term liabilities and one year in current portion of long-term debt.
Once the second 12 months payments are made, there is only one year left in current liabilities and no payments in long-term liabilities.
For some construction companies, there is an additional current liability account called overbillings. This is where your company has billed more than the value of the work that has been performed. This is a liability to the company because it has to perform work that it has been paid for in advance.
In summary, current liabilities are debts that must be repaid within one year. Let’s look at the other liability segment, long-term liabilities.
Long-term liabilities are debts that are repaid in longer than one year. These are notes payable and owner’s payables. There are several types of notes. They include vehicle notes, mortgages, and notes to previous owners. Only one year’s payments go into current liabilities. The rest of the principal payment amount goes into long-term liabilities.
If an owner loans the company money that will be repaid in longer than one year, this loan also goes into long-term liabilities. In summary, the liabilities segment of the balance sheet is divided into two categories — current liabilities that must be repaid within one year, and long-term liabilities that are repaid in a term longer than one year. The final segment of the balance sheet is net worth.
Net worth is what would be left if your company had to liquidate all of its assets to pay its liabilities. There are two major categories in net worth: stockholder’s or owner’s equity, and retained earnings. Stockholder’s equity is the value that stockholders have invested in the business. This could have been during the start of the business or as additional stock investments during operation of the business.
Many times owners sell stock to employees or other investors. This stock value goes in the net worth segment. Retained earnings are that portion of the company’s profits that the company didn’t distribute as dividends at the end of its fiscal year. Most contractors don’t take dividends. If they take a distribution, they take it as a bonus. (The bonus is expensed on the income statement before profits are calculated).
Retained earnings grow from year to year, as long as the company is profitable. For an unprofitable year, retained earnings shrink. As company profits increase then the net worth of the business increases. As profits decrease, the net worth of the business decreases.
In summary, I look at net worth as what I call the “fudge factor.” If you could sell this business tomorrow, what would it be worth on paper? And the way to arrive at this number is to subtract liabilities from assets; i.e., turn all assets into cash and pay off all liabilities. Whatever is left is what the business is worth.
The balance sheet is a snapshot of the health of your business at one moment in time. It tracks your assets, your liabilities, and your net worth. Tracking these numbers is important to ensure that the business remains viable.
Ruth King has over 25 years of experience in the hvacr industry and has worked with contractors, distributors, and manufacturers to help grow their companies and become more profitable. She is president of HVAC Channel TV and holds a Class II (unrestricted) contractors license in Georgia. Ruth has written two books: The Ugly Truth About Small Business and The Ugly Truth About Managing People. Contact Ruth at email@example.com or 770.729.0258.