A liability is a legal obligation that an organization or individual owes to another organization or individual.
In accounting liabilities make up the right side of an organization’s balance sheet, and include loans, mortgages, accounts payable, accrued expenses and deferred revenues.
Liabilities in Business Accounting
Liabilities and their counterpart assets form the foundation of all business accounting. Everything that a company owns, owes or exchanges must be recorded in their balance sheet, and a company’s liabilities are just as important as its assets when performing a valuation.
When performing fundamental analysis on a company, the nature of the company’s liabilities are of critical importance. A company that cannot meet its obligations in a timely manner faces penalties, a loss of reputation, broken contracts, higher borrowing costs and bankruptcy.
Furthermore, companies with a poor balance sheet may need to take on increasingly costly debt to temporarily plug gaps in its obligations, which only further worsens the state of its liabilities in the long run.
While balance sheets should be interpreted holistically, it is generally a company’s liabilities and not its assets that cause it problems and lead to crises.
Not all obligations are created equal, and companies with liabilities that are poorly and unfavorably structured will have trouble competing with companies that are based on a more sound financial footing.
Liabilities and Trading
There are a number of different ways that day traders can use a company’s liabilities to create profitable trading positions, but most of them are based on forecasting an upcoming structural change to a company’s balance sheet.
For example, a company that will likely be able to refinance its existing loans on more favorable terms will generally receive a quick boost in the price of its shares.
Conversely, a company that is forecast to be unable to meet some or all of its interest payments is likely to see its share price fall dramatically.
Understanding company liabilities and their impact on a company’s share price is a part of fundamental analysis, which examines income statements, balance sheets and other company documents and outside news to determine whether the current share price of a company is undervalued, overvalued or accurate.
Fundamental analysis rarely looks at any one area individually, such as liabilities, but it would not be unheard of for a day trader to focus on liability analysis as part of a more comprehensive day trading strategy based on fundamental analysis.
In particular day traders can focus on upcoming debt payments and refinancing opportunities as viable sources of profitable trades.
Understanding the basics of assets, liabilities, balance sheets, income statements and so on is essential for any day trader who wishes to trade in equities.
Day traders who rely on fundamental analysis to generate their trades will become familiar with company liabilities as part of their comprehensive overview of companies’ official filings.
However, day traders may also develop trading strategies that focus in particular on company liabilities, especially in the areas of debt repayment and loan refinancing.