Financial obligations that are not expected to be settled within one year
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A non-current liability refers to the financial obligations in a company’s balance sheet that are not expected to be paid within one year. Non-current liabilities are due in the long term, compared to short-term liabilities, which are due within one year.
Analysts use various financial ratios to evaluate non-current liabilities to determine a company’s leverage, debt-to-capital ratio, debt-to-asset ratio, etc. Examples of long-term liabilities include long-term lease obligations, long-term loans, deferred tax liabilities, and bonds payable.
A non-current liability refers to the financial obligations of a company that are not expected to be settled within one year.
Examples of non-current liabilities include long-term leases, bonds payable, and deferred tax liabilities.
Investors and creditors review non-current liabilities to assess solvency and leverage of a company.
Understanding Non-Current Liabilities
Non-current liabilities are one of the items in the balance sheet that financial analysts and creditors use to determine the stability of the company’s cash flows and the level of leverage. For example, non-current liabilities are compared to the company’s cash flows to determine if the business has sufficient financial resources to meet arising financial obligations in the organization.
If the company enjoys stable cash flows, it means that the business can support a higher debt load without increasing its risk of default. However, if its non-current liabilities are inadequate, then investors will be hesitant to invest in the company, and creditors will shy away from doing business with it.
Key Financial Ratios that Use Non-Current Liabilities
Investors, creditors, and financial analysts use various financial ratios to assess the non-current liabilities to determine the leverage and liquidity risk of a company. Some of the ratios include:
1. Debt Ratio
The debt ratio compares a company’s total debt to total assets to determine the level of leverage of a company. It shows the portion of the company’s capital that is financed using borrowed funds. The lower the percentage, the less leverage a company has, and the stronger its equity position.
A high percentage shows that the company has high leverage, which increases its default risk. A debt to total asset ratio of 1.0 means the company has a negative net worth and is at a higher risk of default.
2. Interest Coverage Ratio
The interest coverage ratio is used to assess whether a company is generating sufficient income to cover interest payments. The ratio is obtained by taking the earnings before interest and taxes (EBIT) and dividing it by the interest expense incurred in a given period. A higher coverage ratio means that the business can comfortably handle its interest payments and take on additional debt.
Types of Non-Current Liabilities
The following are the main types of non-current liabilities that are included in the balance sheet:
1. Credit lines
A credit line is an arrangement between a lender and a borrower, where the lender makes a specific amount of funds available for the business when needed. Instead of getting lump-sum credit, the business draws a specific amount of credit when needed up to the credit limit allowed by the lender.
A credit line is usually valid for a specified period of time when the business can draw the funds. If a business draws funds to purchase industrial equipment, the credit will be classified as a non-current liability.
2. Long-term lease
Lease payments are common expenditures that companies are required to meet to fulfill their purchase commitments. Companies use capital leases to finance the purchase of fixed assets, such as industrial equipment and motor vehicles.
If the lease term exceeds one year, the lease payments made towards the capital lease are treated as non-current liabilities since they reduce the long-term obligations of the lease. The property purchased using the capital lease is recorded as an asset on the balance sheet.
3. Bonds payable
A bond is a long-term lending arrangement between a lender and a borrower, and it is used as a means of financing capital projects. Bonds are issued through an investment bank, and they are classified as long-term liabilities if the payment period exceeds one year. The borrower must make interest payments at fixed amounts over an agreed period of time, usually more than one year.
4. Notes payable
A note, also called a promissory note, is a special type of loan arrangement where a borrower makes an unconditional promise to pay back the principal plus interest to the lender. The promissory note is used to finance the purchase of assets such as machinery and buildings. If the maturity period of the note exceeds one year, it is considered a non-current asset.
5. Deferred tax liabilities
Deferred tax liabilities refer to the amount of taxes that a company has not paid in the current period, and that are required to be paid in the future. The liability is calculated by finding the difference between the accrued tax and the taxes payable. Therefore, the company will be required to pay more tax in the future due to a transaction that occurred in the current period for which tax has not been remitted.
Thank you for reading CFI’s guide to Non-Current Liability. To keep learning and developing your knowledge of financial analysis, we highly recommend the additional resources below:
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