Understanding liabilities
The answer
A liability is money the company must pay somebody else. The balance sheet splits them by when they are due: within 12 months, or later.
The obligations that end companies are usually not the ones on the balance sheet. They are in a note at the back called contingent liabilities, and they are not counted in any total.
Why this costs you money
You check a company's debt. Total borrowings are ₹1,800 crore against equity of ₹5,200 crore. A debt-to-equity ratio of about 0.35. Comfortable. You buy.
Eighteen months later the company loses a tax case and has to pay ₹2,400 crore. The number had been disclosed for 6 years, in a note titled "Contingent liabilities and commitments", and it was never part of the ₹1,800 crore you checked, because contingent liabilities are not on the balance sheet at all.
This is the most common expensive gap in retail analysis, and it has a simple structural cause. Screeners, broker apps and stock websites take their debt figure from the balance sheet. Contingent liabilities are not on the balance sheet. So they are absent from every automated tool you use, and present in the document you did not open.
The second version of the same mistake is quieter. You check total debt but not when it is due. A company with ₹1,800 crore of borrowings, of which ₹1,500 crore must be repaid or refinanced within 12 months, is in a completely different position from one with the same ₹1,800 crore due over 9 years. The balance sheet tells you which. It is 2 separate lines, and most people add them together and stop.
Companies rarely fail because of the size of their debt. They fail because of the timing of it, and because of an obligation nobody had counted.
How it works
Liabilities divide the same way assets do: current, meaning due within 12 months, and non-current, meaning due later.
The main current liabilities
Short-term borrowings. Working capital loans, cash credit facilities, commercial paper. Rolled over regularly, which requires a lender who is willing. When lenders stop being willing, this line becomes due immediately.
Current maturities of long-term debt. The portion of long-term loans falling due within the next 12 months. In Indian reports this often sits inside "other financial liabilities" rather than under borrowings, which is why people miss it. Find it. It is real debt due soon.
Trade payables. Money owed to suppliers for goods and services already received. Suppliers usually charge no interest, so this is free funding. A company that stretches its payables from 45 days to 110 days has borrowed from its suppliers without a loan agreement. That is a sign of cash difficulty, not of negotiating strength.
Provisions. Amounts set aside for costs the company expects but has not yet paid: employee benefits, warranty claims, restructuring costs. Recorded when an obligation is probable and can be estimated reliably.
Current tax liabilities. Tax due and not yet paid.
The main non-current liabilities
Long-term borrowings. Term loans, bonds, debentures. Read the note. It states the interest rate, the repayment schedule, and what security the lender holds.
Lease liabilities. Since Ind AS 116 and its American equivalent ASC 842, most leases sit on the balance sheet as a liability, with a matching right-of-use asset. Before those standards, a company that leased 400 stores showed no debt for them. The change made many retailers and airlines look far more indebted overnight, with no change in the business.
Deferred tax liabilities. Tax the company will owe later because of timing differences between accounting profit and taxable profit.
Long-term provisions. Mostly retirement benefit obligations. For a company with a defined benefit pension scheme this line can be enormous, and it moves with interest rates.
The ones that are not there
Contingent liabilities are possible obligations that depend on a future event the company does not control, or present obligations that cannot be measured reliably. The rule under both Ind AS 37 and the American standard ASC 450 works in 3 levels.
| Likelihood | What the company must do |
|---|---|
| Probable, and can be estimated | Record it as a provision, on the balance sheet |
| Possible but not probable | Disclose it in the notes only |
| Remote | Say nothing |
The middle row is where contingent liabilities live. Typical contents:
- Disputed tax demands under appeal. Very large in Indian reports.
- Claims from customers, suppliers and regulators in litigation.
- Guarantees given on behalf of subsidiaries, joint ventures and associates. The company has promised to pay a lender if another company in its group does not.
That third one is the dangerous one. It is the mechanism by which a parent company that looks unindebted can be responsible for the debt of 40 companies you have never heard of.
What it tells you, and what it does not
Liabilities tell you who has a claim on the company's cash before you do, how much they can demand, and when.
They do not tell you the company is in trouble. Debt is a tool. A stable business with predictable cash can carry a great deal of it safely. A cyclical business can be destroyed by a fraction as much.
They do not tell you whether the contingent items will happen. Indian tax authorities routinely raise demands that are later reduced or dropped. Treating the contingent liabilities total as debt would be wrong.
And they do not, on their own, show refinancing risk. A company with ₹5,000 crore due next year is fine if lenders will roll it over and dead if they will not. The balance sheet cannot tell you which. The credit rating and the interest cost can.
The decision rule
Judge debt by 3 questions, in this order: when is it due, what does it cost, and what happens if nobody refinances it.
If current liabilities exceed current assets and short-term borrowings are rising while operating cash is flat, the company is depending on lenders continuing to say yes — unless it is a business that collects cash before it pays suppliers, in which case negative working capital is the normal and healthy state.
And separately: if contingent liabilities exceed total equity, the company's survival depends on the outcome of things it does not control.
Try this now
Fifteen minutes, on 1 holding. You are going to find the obligations that no screener shows you.
- Open the latest annual report for 1 holding. Go to the notes to the financial statements, not the balance sheet.
- Search the document for the word contingent. In an Indian annual report look for a note titled "Contingent liabilities and commitments". In an American 10-K look for "Commitments and Contingencies" in the notes, and also read Item 3, Legal Proceedings.
- Write down the total of contingent liabilities. Note the breakdown: how much is disputed tax, how much is other litigation, and how much is guarantees given for other companies.
- Now go back to the balance sheet and write down total equity.
- Divide contingent liabilities by total equity.
- Finally, on the balance sheet and its notes, find 2 more numbers: short-term borrowings, and current maturities of long-term debt. Add them. That sum is what must be repaid or refinanced within 12 months.
- Compare that sum to the year's cash from operations, which you already found in article 1 of this cluster.
What you should see. For most large, stable companies the contingent liabilities figure is a small fraction of equity, and it is mostly tax disputes that have been running for years.
If the ratio in step 5 is above 1, stop and read the breakdown properly. The disclosed possible obligations are larger than everything shareholders own.
If guarantees given to subsidiaries and associates are a large part of the total, you have found the group structure risk. The parent you analysed is not the entity that is exposed.
In step 7, if the 12-month repayment requirement is larger than a full year of operating cash, the company must refinance to survive the year. That is not unusual and not fatal. It is a dependency, and now you know it exists.
Three real cases
1. IL&FS, September and October 2018 (India) — debt spread across hundreds of entities Infrastructure Leasing and Financial Services was rated AAA and treated as close to government-backed. In July 2018 one of its road subsidiaries reported difficulty making bond payments. In September 2018 IL&FS Financial Services defaulted on commercial paper and on ₹450 crore of inter-corporate deposits owed to SIDBI, and on 27 September 2018 informed the BSE of further defaults. Group debt was around ₹94,000 crore, spread across roughly 250 group companies. On 1 October 2018 the Government of India superseded the board. The debt was not invisible. It was distributed across an entity structure almost no outside investor had mapped, and cross-guarantees linked entities that looked separate. The SFIO investigation later reported major lapses in the audit work.
2. Enron Corporation, 16 October 2001 (United States) — the liabilities were in entities that were not consolidated Enron used hundreds of special purpose entities. Debt was placed in those entities and, under the consolidation rules of the time, they were not added into Enron's balance sheet, so Enron reported far less debt than the group carried. On 16 October 2001 it restated results, increasing reported liabilities by $628 million and reducing shareholders' equity by $1.2 billion. It filed for bankruptcy on 2 December 2001. The consolidation rules were tightened afterwards, which is the standard sequence: a structure is used, a company fails, the rule changes.
3. Carillion plc, 15 January 2018 (United Kingdom) — the pension obligation was larger than the debt Carillion collapsed into compulsory liquidation on 15 January 2018 with roughly £900 million of debt and about £29 million of cash. Its defined benefit pension schemes, covering around 27,000 members across 13 schemes, carried a deficit estimated at approximately £2.6 billion, nearly 3 times the borrowings. In April 2018 the Official Receiver estimated total liabilities of the liquidated UK companies at around £6.9 billion. An investor who checked "debt" and stopped there had checked the smaller number.
The question that resolves it
A novice looks at the liability side and asks: how much debt is there?
An expert asks: who can demand money in the next 12 months, and what would happen if they all did?
That reframing does 3 things at once. It brings in short-term borrowings and current maturities, which the simple debt figure often understates. It brings in trade payables, which are not debt but are still a demand on cash. And it brings in the contingent items, which are not on the balance sheet but can become payable in a single court ruling.
What would make this wrong
If contingent liabilities were reliably real, then companies with large disclosed tax disputes would routinely be destroyed by them. In India they mostly are not. Tax demands are frequently raised at aggressive amounts and settled or dropped years later for a fraction.
Three honest limits.
Contingent liabilities are a range of possibilities, not a number. Adding the total to debt would overstate the risk badly. The right use is as a trigger to read the detail: what kind of claim it is, how old it is, and what the company says about the likely outcome.
Negative working capital is a business model in some industries. Supermarkets, airlines selling tickets in advance and subscription software companies all collect from customers before they pay suppliers. They show current liabilities far above current assets, permanently, and they are healthy.
Lease liabilities changed the comparison, not the risk. When Ind AS 116 and ASC 842 brought leases on to the balance sheet, retailers' reported debt jumped with no change in the businesses. Comparing a company's debt-to-equity today against its own figure from before the standard applied compares 2 different definitions.
In India
Schedule III fixes the presentation, and 3 features matter to a reader.
The contingent liabilities and commitments note is prescribed. It has a standard structure: claims against the company not acknowledged as debts, guarantees, and other money for which the company is contingently liable, plus commitments such as contracted capital expenditure. Because the format is fixed, you can compare it across companies and across years easily.
Trade payables are split by counterparty type. Schedule III requires separate disclosure of amounts due to micro and small enterprises, under the MSMED Act, from amounts due to others, along with an ageing table. A company delaying payment to small suppliers is disclosing that fact by law.
CARO makes the auditor answer specific questions about debt. Under the Companies (Auditor's Report) Order, the auditor must state whether the company has defaulted in repayment of loans or interest, and give details of the default and the period. The auditor must also report on loans and guarantees given to related parties. That is a direct, written answer to a question that in most countries you would have to work out yourself.
Related party disclosure is stronger in India, because most listed Indian companies have a controlling promoter group. Under SEBI's listing regulations, material related party transactions require shareholder approval, with the promoter group unable to vote. The threshold for a material transaction is ₹1,000 crore or 10% of annual consolidated turnover, whichever is lower.
In the United States
American liability disclosure has a different centre of gravity: it is heavier on narrative and litigation, lighter on prescribed tables.
Commitments and contingencies appear as a note in the financial statements, governed by ASC 450. The recognition test is "probable and reasonably estimable" for accrual, and "reasonably possible" for disclosure. Where a loss is reasonably possible, the company must disclose an estimate of the range, or state that an estimate cannot be made.
Item 3, Legal Proceedings in the 10-K describes material lawsuits separately from the notes. Read both. They do not always contain the same detail.
Item 7, MD&A, contains a liquidity and capital resources section. Management explains, in sentences, how it intends to fund itself over the next 12 months, what credit facilities it has, and what covenants apply. There is no Indian equivalent of comparable consistency, and for a reader worried about debt it is the most useful page in the filing.
Debt covenants are usually described. A covenant is a condition in a loan agreement, such as a maximum debt-to-earnings ratio. Breaking one can make the loan repayable immediately, which turns long-term debt into current debt in a single day. American filings discuss covenants more openly than Indian ones do.
Where they differ, and what that tells you
Both countries require the same 3-level treatment of contingencies: accrue, disclose, or say nothing. The divergence is in where the pressure is applied.
India applies pressure through prescribed disclosure. Schedule III fixes the table. CARO forces the auditor to answer named questions about defaults, loans and guarantees. SEBI forces shareholder approval for large related-party deals. The system assumes the risk is a controlling owner moving money and obligations between connected companies, and it responds by demanding structured data.
The United States applies pressure through narrative and personal liability. MD&A requires management to explain its own liquidity position in writing. Risk Factors require it to list what could go wrong. Sarbanes-Oxley requires the chief executive and chief financial officer to certify the filing personally. The system assumes the risk is management telling a misleading story, and responds by making them tell it under their own signature.
What that tells you is where a group structure can hide. In India the structured disclosures are excellent, but they describe the reporting entity. A group of 250 companies can be individually compliant while nobody outside understands the group as a whole.
So in India, for any company with a complicated group, the guarantees line inside the contingent liabilities note is the most important line in the report. Read it first, and read the related party note beside it. In the United States, read the liquidity section of MD&A first, then check whether the numbers support what it says.
Carry this
- Timing beats size. When is it due matters more than how much.
- Contingent liabilities are on no screener and in no total. Open the note.
- Guarantees given to group companies are the line that turns a clean balance sheet into somebody else's problem.