Limited Companies - Part 1

A limited company is a business organisation that has been incorporated — it is recognised in law as a separate legal entity, completely distinct from its owners (shareholders). This has several important consequences:

Limited liability: Shareholders can only lose the amount they paid (or agreed to pay) for their shares. If the company fails and has debts, creditors can only claim against the company's assets — not against shareholders' personal property. This is the key advantage over a sole trader or partnership, where owners have unlimited liability.

Separate legal entity: The company can own property, enter contracts, sue, and be sued in its own name. The death or departure of a shareholder does not end the company's existence.

Types of limited company:

• Private limited company (Ltd): shares cannot be offered to the general public; often family-owned or small businesses.
• Public limited company (PLC): shares are traded on a stock exchange and can be bought by anyone.

At IGCSE level, you need to know the general features common to both types rather than the detailed legal distinctions between them.

Governance: Shareholders elect a board of directors to manage the company on their behalf. This creates the agency relationship discussed in stewardship — directors are accountable to shareholders.

Advantages of limited liability:

• Shareholders are willing to invest knowing they cannot lose more than their investment.
• Companies can raise large amounts of capital by issuing many shares to many investors.
• The business continues even if individual shareholders sell their shares.

Companies can issue different types of shares (also called equity). The two main types at IGCSE level are:

Ordinary shares:

• The most common type of share; holders are the true owners of the company.
• Variable dividend: the dividend changes each year depending on the company's profits. Directors recommend a dividend; shareholders vote to approve it.
• Voting rights: ordinary shareholders vote at the AGM, elect directors, and approve major decisions.
• Residual claimants: if the company is wound up, ordinary shareholders receive what remains AFTER all debts and preference dividends are paid — they bear the most risk.
• Higher risk, higher potential reward (if the company does very well, dividends can be large; if it does poorly, no dividend may be paid).

Preference shares:

• Holders receive a fixed percentage dividend calculated on the nominal value (e.g., 5% preference shares of $1 each pay 5 cents per share per year).
• Dividends are paid to preference shareholders before ordinary shareholders.
• Usually no voting rights (or limited voting rights in specific circumstances).
• Cumulative preference shares: if the dividend cannot be paid in a year, it accumulates and must be paid in a future year before ordinary shareholders receive anything. (Note: understand the concept; detailed calculations not required at IGCSE.)
• Lower risk: the fixed dividend provides more certainty than ordinary shares; preference shareholders also have priority on winding up over ordinary shareholders (but after creditors).

The terminology around share capital is a common source of exam errors. Learn each term precisely:

Authorised (or nominal) share capital: The maximum amount of share capital a company is legally permitted to issue, as stated in its constitutional documents (Memorandum of Association / Articles of Association). This is a ceiling — the company does not have to issue all of it.

Issued share capital: The shares that have actually been issued to shareholders. Issued share capital ≤ Authorised share capital. The company can only issue more shares up to the authorised limit (or by changing the authorised capital with shareholder approval).

Called-up capital: When shares are issued, the company may not always ask for the full payment immediately. Called-up capital is the portion of issued capital that the company has requested from shareholders.

Paid-up capital: The portion of called-up capital that shareholders have actually paid. In practice, at IGCSE level most questions assume all called-up capital has been paid, so called-up and paid-up are usually the same amount.

Share premium: When shares are issued at a price above their nominal (face) value, the excess is the share premium.

Example: A company issues 1 000 shares with a nominal value of $1.00 each at $1.50 per share.

• Share capital: 1 000 × $1.00 = $1 000 (at nominal value)
• Share premium: 1 000 × $0.50 = $500
• Total proceeds: $1 500

The share premium appears in the capital and reserves section of the SFP — it cannot be paid out as a dividend.

Debentures: A debenture is a form of loan capital — the company borrows money from debenture holders, who are creditors (not owners). Key features:

• Debenture holders receive fixed interest at the agreed rate, regardless of whether the company makes a profit.
• Debenture interest is an expense — it appears in the income statement (lower section), deducted before tax and profit available for distribution.
• Debentures are non-current liabilities on the SFP (assuming they are long-term).
• Debenture holders do NOT have voting rights; they are creditors, not shareholders.

Contrast with preference shares: Both have a fixed return, but preference shares are equity (capital), while debentures are debt (liability). Debenture interest is an expense; preference dividends are an appropriation of profit.

Retained earnings (retained profit): After all expenses (including debenture interest and tax) are deducted and dividends are paid, any remaining profit that is kept in the company is called retained earnings (or retained profit).

Retained earnings accumulate year after year in the company — they are NOT paid to shareholders. They appear in the capital and reserves section of the SFP. Retained earnings can be used for future investment, to fund operations, or to pay future dividends.

General reserve: Sometimes the company transfers part of retained earnings to a general reserve. This is a deliberate decision by directors to set aside profits for future purposes. The general reserve also appears in the capital and reserves section.