Possible Answers
LIMITED LIABILITY
Case Study: Greg Pallow, a self-employed painter and decorator was delighted to win a
£20,000 contract to decorate a big hotel. The work came just in time, as he was at the limit of
his bank overdraft. He picked up £8,000’s worth of decorating materials, using his credit
account at the local DIY merchants. He would not have to pay for three months.
Although Greg didn’t have the money at the moment to pay for these materials, when the hotel paid him
he could settle his account and make a tidy profit. Greg completed the work, but before the hotel sent
him the cheque, disaster struck. There was a fire, the hotel burned down, and was not fully insured. The
company that owned the hotel went bankrupt and it was announced that Greg was just one of a long line
of creditors. He would not get paid, but the shop that provided Greg with the paint and wallpaper still
wanted its money – and was determined Greg would pay up, even if doing so forced him out of business.
1. Explain the meaning of the terms below. Use an example from the case study for each one.
Overdraft
An overdraft is a way of borrowing money from a
bank. If Greg has an overdraft facility of £400, he
can spend up to £400 more than is in his bank
account. He pays interest whenever he is overdrawn.
Credit
Credit is a way of obtaining goods or services
without having to pay for them straight away.
Greg took decorating materials on credit.
Bankrupt
Greg will be declared bankrupt if he has debts that he
cannot pay. He may have to go into liquidation,
which means his firm is sold; the money raised going
towards paying his debts.
Creditors
A creditor is someone that Greg owes money to.
The DIY merchants are Greg’s creditors because
he took the DIY materials with a view to paying
them in three months time.
Greg cannot pay the builders’ merchants the money he owes for the materials. He does not have £8,000.
All he has is a car worth £2,000 and a share in a flat, which would be worth £10,000.
Situation 1
Greg is a sole trader. This means he has
unlimited liability, and is responsible for all the
debts of his business.
Situation 2
Greg had formed a limited company called Pallow
Decoration Limited. This gives him the protection
of limited liability, should his firm go bankrupt.
2. What would happen to Greg if he were a sole trader as in situation 1? Use at least twenty words.
If Greg were a sole trader, he would be liable for all the debts of his business. This would mean that he
would have to sell all the assets of the business to pay the DIY merchants. If this did not raise enough
money to pay his creditors, then Greg would have to sell his personal possessions until he had enough
money to pay his debts. This would involve him selling his car and flat. If he raised £12,000 by selling
them, then he would pay his creditors and have £4,000 left but nowhere to live and no transport.
3. What would happen to Greg if he were a limited company as in situation 2? Use at least twenty words.
If Greg had formed a limited company, then he would have limited liability and would not have to lose any
of his personal possessions if he went bankrupt. His business would still have to go into liquidation, and
while losing his firm may be bad, at least he would not have to sell his car and house. Limited liability
gives entrepreneurs some security if things do not work out. They do not risk losing everything.
ials on three months credit from the local builders’ merchant.
4. Why is it easier for a sole trader to obtain a bank loan than a limited company? Use the word risk.
A bank will be more likely to lend money to a sole trader because it knows that it is more likely to get its
money back even if the business fails. A limited company is a bigger risk, because the owners of the firm
can declare themselves bankrupt if they cannot pay back the loan, without ever risking their own
possessions. A sole trader will be risking much more than a limited company in taking out a loan. Banks
know this, and often require directors of limited companies to put up personal guarantees as security.
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