Limited companies

Welcome to the World of Limited Companies!

Hello! Today, we are going to explore Limited Companies. So far, you might have learned about Sole Traders (one-person businesses) and Partnerships (small groups). But what happens when a business wants to become a giant? That is where Limited Companies come in!

In this chapter, we will learn how these big businesses are structured, how they raise money, and how their financial statements look a little different from what you’ve seen before. Don't worry if it seems like a lot of new terms—we’ll break them down step-by-step!

1. What is a Limited Company?

A Limited Company is a business that has its own legal identity. This means the law sees the company as a "person" separate from the people who own it.

The Concept of Limited Liability

The most important thing to understand is Limited Liability. Imagine you invest £100 in a company. If that company goes into huge debt, the most you can lose is that £100. The people the company owes money to cannot come after your house or your car. Your risk is limited to what you put in.

Analogy: The Safety Wall
Think of Limited Liability as a giant brick wall between the company’s debts and your personal piggy bank. The debts can hit the wall, but they can't jump over it to get to you!

Key Differences from Sole Traders:

• Ownership: Owned by Shareholders.
• Control: Managed by Directors (who are elected by shareholders).
• Profits: Shared through Dividends.

Quick Review: Why do people prefer limited companies? Because if the business fails, the owners' personal assets are safe!

2. Share Capital: How Companies Get Money

To start or grow, a company sells pieces of itself called Shares. When you buy a share, you become a Shareholder (an owner).

Types of Shares

There are two main types of shares you need to know for your exam:

1. Ordinary Shares: These are the "standard" shares. Owners get voting rights but are the last to get paid if the company closes down. Their dividends can change—if the company makes a huge profit, they might get a lot; if it makes zero profit, they get nothing.

2. Preference Shares: These owners get a fixed dividend (like a set percentage). They are "preferred" because they get paid before the ordinary shareholders. However, they usually don't have voting rights.

Understanding Share Terms

Sometimes the math here can be confusing. Let's look at the "stages" of share capital:

• Authorized Capital: The maximum amount of shares the company is allowed to sell.
• Issued Capital: The amount of shares the company has actually sold to people.
• Called-up Capital: The amount the company has asked shareholders to pay.
• Paid-up Capital: The amount of money the shareholders have actually sent in.

Memory Aid: Think of Authorized capital as the "Limit" on a credit card, and Issued capital as what you have "actually spent."

Key Takeaway: Ordinary shareholders take more risk but have more control. Preference shareholders take less risk and get a steady, fixed return.

3. Reserves: The Company's Savings Accounts

A company doesn't just have "Capital." It also has Reserves. These are parts of the profit or value kept in the business rather than paid out to owners.

The Two Main Types of Reserves

1. Revenue Reserves: Created from daily profits. The most common is Retained Earnings (or Retained Profits). This is money kept from the year's profit to reinvest in the business.

2. Capital Reserves: Created from non-trading activities. The most common is the Share Premium account. This happens when a company sells a share for more than its face value (nominal value).

Example: If a £1 share is sold for £1.50, the £1 goes to Share Capital, and the \( 0.50 \) goes to the Share Premium account.

Calculation: \( \text{Total Received} - \text{Nominal Value} = \text{Share Premium} \)

Did you know? A company cannot usually pay out Capital Reserves (like Share Premium) as cash dividends. They are "locked" away for specific uses!

4. Debentures: Borrowing Money

Sometimes a company doesn't want to sell more shares. Instead, they borrow money from the public using Debentures.

A Debenture is a long-term loan. The company pays a fixed rate of interest every year, regardless of whether they made a profit or a loss. In the Statement of Financial Position, these are listed under Non-current Liabilities.

Common Mistake to Avoid: Don't confuse Dividends with Debenture Interest!
- Dividends are a share of profit (optional).
- Interest is a cost of borrowing (compulsory expense).

5. Financial Statements for Limited Companies

When preparing accounts for a company, the format is slightly different from a Sole Trader because we have to show how the profit is distributed.

The Statement of Profit or Loss

This looks mostly the same, but you must subtract Finance Costs (Interest) and Tax to find the "Profit for the year."

\( \text{Operating Profit} - \text{Finance Costs} - \text{Tax} = \text{Profit for the Year} \)

The Statement of Changes in Equity (SOCIE)

This is a new table for you! It shows how the "Equity" (the money belonging to owners) changed during the year. It tracks:

• Opening Balances of Capital and Reserves.
• Plus: Profit for the year.
• Plus: New shares issued.
• Minus: Dividends paid during the year.
• Closing Balances.

The Statement of Financial Position (SFP)

Instead of just a "Capital" section, we have an Equity section which includes:

• Share Capital (Ordinary and Preference)
• Share Premium
• General Reserve
• Retained Earnings

Quick Review Box:
Equity = Share Capital + Reserves
In a company, the accounting equation is still: \( \text{Assets} = \text{Liabilities} + \text{Equity} \).

6. Dividends: The Reward

Dividends are the way shareholders get a "thank you" for investing. There are two types you might see in a question:

1. Interim Dividends: Paid halfway through the year.

2. Final Dividends: Decided at the end of the year.

Important Rule: Under IAS (International Accounting Standards), we only record dividends in the accounts if they have actually been paid or formally approved during the year. If a dividend is just "proposed" at the end of the year, it is usually just a note and doesn't go into the main numbers yet.

Key Takeaway: Dividends reduce the Retained Earnings in the Equity section. They are not an expense in the Profit or Loss account!

Final Summary Checklist

Before you tackle some practice questions, make sure you can answer these:

• Can I explain what Limited Liability means?
• Do I know the difference between Ordinary and Preference shares?
• Can I calculate Share Premium?
• Do I remember that Debenture Interest is an expense, but Dividends are not?
• Do I know that Equity = Share Capital + Reserves?

Don't worry if this seems tricky at first! The more you practice the layout of the Statement of Changes in Equity, the more natural it will feel. You've got this!