Examples of Transactions That Increase One Liability and Decrease Another

Understanding the dynamics of liability transactions is crucial for effective financial management, particularly in corporate and small business environments. In this article, we will explore several examples where one liability increases while another decreases. By examining these scenarios, business owners and financial managers can make informed decisions to optimize their financial strategies.

Government of India's MSME Policy

To illustrate this concept, consider the Government of India's MSME policy. Under this policy, large corporates often face the challenge of delayed payments from smaller units. To mitigate this risk, these corporates may choose to purchase their requirements from large-scale units. This approach can help large companies manage their supply chain better and ensure timely payments to their stakeholders. Small and medium enterprises (SMEs) that qualify for preferential treatment might find it easier to secure procurement opportunities from larger entities, thereby improving their financial standing.

Corporate Debt Restructuring

A common scenario in the financial world involves the conversion of debt into equity as part of corporate restructuring. Let's take an example where a bank agrees to convert a portion of its loan to a company into equity. In this case:

Bank borrowing decreases (liability decreases) Equity capital increases (another liability increases)

This type of transaction is particularly useful for companies looking to reduce their debt burden and improve their financial health.

Personal Finance Example - Repaying a Bank Loan

Imagine a situation where an individual, due to unforeseen financial difficulties caused by the Covid pandemic, is unable to make regular payments on a bank loan. To prevent adverse effects on their credit score, they borrow money from a friend and use it to repay the bank:

Transaction Entry:

Debit: Bank Loan A/c Credit: Friends Loan A/c

In this scenario, the liability under the bank loan (which has a credit balance) is reduced, while the liability from the friend's loan is increased. This illustrates how financial difficulties can lead to the creation of new liabilities to manage existing ones.

Use of Cash Credit Facilities

Cash credit (CC) facilities provided by banks are often used by companies for short-term financing. Let's consider a situation where a company has already depleted its CC facility and now needs to pay a creditor for goods received in two previous orders. The company decides to use its CC to make the payment:

Transaction Entry:

Credit: Creditor fr Goods Party Name A/c Debit: CC Bank A/c

This transaction demonstrates how the use of an existing credit facility increases one liability (CC payable) while reducing another liability (creditor balance).

Managing Multiple Liabilities

Businesses often find themselves in situations where they must balance multiple liabilities. For example:

1. Decrease Accounts Payable by Increasing CC Payable: A company might decide to stretch out payments to vendors, increasing its Accounts Payable liability, and use those funds to pay down its Line of Credit (LOC) Debt liability. Alternatively, a company might choose to do the opposite—pay down its Accounts Payable with a LOC while extending its Payables.

2. Pay Down Current Liabilities: Companies can also use cash or other liquid assets to pay down current liabilities, reducing them while potentially introducing new short-term liabilities.

Understanding these scenarios is essential for effective financial management and planning. By strategically managing liabilities, businesses can reduce financial risks and improve overall financial health.