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Which of these five common business structures is right for your future company?

Guide to the benefits and drawbacks of five common business structures

by Forma on

October 29, 2019

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For small business owners and freelancers who have just started out, staying on top of your business finances and documents can be daunting. Here’s where our article comes in, so you can quickly get a grip on the basics.

What is a balance sheet?

A balance sheet provides a snapshot of the financial condition of a company, showing how much it owns (assets), owes (liabilities) and the amount that is left over for its owners (owners’ equity) at a specific point in time. 

The balance sheet is typically completed at the end of a month or a financial year. It is comprised of three main elements:

  • Assets: These are resources that you own and can be sold. Examples include cash, vehicles, inventory and equipment. 
  • Liabilities: These are your business’ legal debts or financial obligations. Examples include loans, accounts payable and salaries payable. 
  • Owners’ (or shareholders’) equity: This refers to the owner’s share of the assets of a company. It includes the share capital (the amount that a company’s owners or shareholders invest in the business) and retained earnings (funds that are retained in the company’s accounts).

The balance sheet is divided into two sections: the left side shows the assets of the company, while the right side shows the liabilities and shareholders’ equity.


Balance Sheet
Balance Sheet

Assets are listed in order of liquidity. For example, cash or inventory are listed above less liquid assets like property or equipment. 

Liabilities are listed in order of maturity; current liabilities, which will come due within a year are listed above long-term liabilities. The latter refers to liabilities that will remain outstanding for longer than one year. 

The total sum of all assets, less a business’ total liabilities is equivalent to the owners’ equity. This represents the amount that would be available for a business owner to draw out.

Why is a balance sheet important?

The balance sheet lets a business owner and investors see what the company owns and owes, and to understand its net worth. It also indicates the financial health of a business. 

For example, a balance sheet that shows a negative balance in owners’ equity indicates that liabilities exceed assets. This can be a warning sign that the company is in a bad financial situation, and should prompt business owners to dive deeper, and uncover the causes for the negative balance. 

A balance sheet can also be used to calculate important financial ratios. One example would be the working capital ratio, which is obtained by dividing the current assets by current liabilities. This ratio measures a business’ efficiency, and shows how well it is able to meet its short-term obligations. 

And for small business owners seeking external financing, the balance sheet —along with financial statements like your cash flow and P&L—are required documents when you apply for a bank loan. 

Balance sheet templates:

example of a profit and loss statement

What is a profit and loss account?

The profit and loss account (P&L) is a financial report that shows the revenue, expenses and profit or loss of your company over a specific accounting period. 

This period can be a month, a quarter or a year. A P&L is also commonly referred to by other terms, such as the income statement, statement of operations, financial results statement and earnings statement. 

A P&L is comprised of the following key elements:

  • Sales or revenue: The amount that your company earns through the sale of goods or services.
  • Cost of goods sold (COGS): The total amount of all costs involved in selling a product during a specified period of time. 
  • Gross profit: Also known as the gross margin, the gross profit refers to a business’ profit before the operating expenses, taxes and interest payments are taken into account. It is calculated by deducting the COGS from the total sales or revenue. 
  • Operating expenses: This refers to expenditures that a company incurs in performing business operations that aren’t directly related to the productions of goods or services. Some examples include salaries, utility payments, administrative expenses and rent.
  • Net profit or loss: The net profit or loss is obtained by deducting total expenses from gross profit.  

Why is the profit and loss account important?

The P&L is a key financial statement in a business plan, as it quickly shows how much money your business has made or lost. 

What’s important is to compare your P&L across different accounting periods. In doing so, you’ll be able to identify business cycles and trends—such as the peak and trough periods that occur across the year, or aspects of your business that generate the most profit or costs. 

You may also identify changes that are not immediately apparent, such as periods where your expenses are growing at a faster rate compared to your revenue. With these insights, you’ll be better-positioned to make improved business and financial decisions. 

And lastly, information from your P&L can also be used to calculate metrics that are important indicators of your company’s financial health. These include the operating ratio, gross profit margin and net profit margin.

P&L templates:

Introduction

If you're looking to the future with the hopes of beginning a journey running your own startup, chances are you're feeling some mixture of excitement, trepidation, and uncertainty when it comes to the finer details of your plan. Starting your own business is an immensely fulfilling process and an excellent means to flex your creative muscles, but there's a lot of humdrum of business behind the process of turning a vision into a dream.

One of the most important (and one of the earliest) decisions in this process will centre around your business's formation. You'll have to select which variety of business structure best suits your goals for the future. While the choice may sound easy, you'll be well-served by giving the decision ample consideration. The business structure you select will have measurable implications on the way you make money and do business. It'll impact:

  • How much tax you pay
  • Your degree of personal liability should the business fail
  • How much administrative work is involved in the business (both before it comes to fruition and over the course of its life)
  • Your ability to finance and fund your efforts

If you make the wrong selection when it comes time to choose a business structure, you could be faced with a myriad of complications in the future. Paying professionals for guidance and advice once things go wrong is costly and, for many, an embarrassing affair-- performing research well in advance will ensure you're making the best choice for your company and that you can avoid losing out on money or pride later on.

The Five Business Structures for UK Startups

There are five business structures that you'll be able to select from as you begin forming your company. We'll dive into each one of them in-depth below, but consider this your primer and introduction to the basics of each structure. Entrepreneurs in the UK can begin a business as a:

Sole trader

·        Simple to operate

·        Unlimited liability

·        Minimal filing duties

·        Registration at Companies House not required

Partnership

·        High liability

·        Two or more partners

·        Taxes are paid separately by each partner on their share of profits

Limited liability partnership

·        Profit-driven

·        Requires at least two members

·        Limited liability

Private limited company

·        Limited liability

·        Simple to operate

·        Potential tax advantages

·        Registration at Companies House required

Guarantee company (non-profit)

·        Profits are reinvested in the company

·        No"owners"-- only decision-makers

·        Taxe xemptions

Sole Trader

Operating as a sole trader is one of the most common ways to begin a business. It's the simplest business structure, the simplest to begin and operate, and the simplest to make changes to later on. Once a business owner establishes themselves as a sole trader, they and their business are seen (legally) as a single entity.

That means a variety of things for business owners. On the plus side, you'll have the freedom to flex your creative and authoritative muscles and make every decision imaginable for your company. Maximum control over your own business is enticing to most-- you get to do all of the decision-making and keep all of the profits that come from your business.

If you elect to operate as a sole trader, you'll also run into a handful of disadvantages. You can hardly claim all of the profits from your business, for example, without being prepared to be held accountable for any of its losses. A great deal of personal risk goes into registering as a sole trader; this isn't a factor which should be overlooked.

Liability

Sole traders face immense liability when it comes to their businesses. They're entirely responsible for running their businesses and ensuring that every step they take is well within the legal requirements set out by the government.

If you register as a sole trader, you'll also be made personally responsible for any debts that your business incurs. In the event that a consumer takes legal action against your business, you'll be held accountable for that, too.

lawyer-typing-on-laptop-at-desk-with-justice-statue-holding-scales

The Ideal Candidates

The ideal candidate for sole tradership likely has a small shop or business with little risk of liability. If you're a little short on cash or other resources to help kickstart your business's beginnings, getting started as a sole trader may be one of your only opportunities to break into the market and start making a profit.

Partnership

A business born as a partnership involves two or more individuals who agree to share that company's profits, losses, risks, costs, benefits, and responsibilities. In some cases, these partnerships are also referred to as unincorporated entities-- which is just a roundabout way of stating that each partner is self-employed and will be held personally responsible for factors like the ones mentioned above.

Perhaps the most notable aspect of a partnership is that each partner is responsible for the others' negligence or misconduct. If you have trouble trusting others or have reservations about your potential partner, you may want to look into separate structuration options for some peace of mind.

If you elect to start a partnership, pay a little extra attention to your partnership agreement document. It'll outline your and your partner's liabilities, explain ownership and profit splits, and detail what will happen if one partner elects to leave the company.

The Ideal Candidates

The ideal candidates for partnership have a reliable, positive history of completing work together in the past. Regardless of whether there are two partners or twenty, it's crucial that the group has full trust in one another. The fact that you'll be held liable for mistakes made by your partners should be reminder enough to select them wisely.

If you find the thought of beginning your business on your own a little daunting, a properly-selected partnership can be a great means of boosting your confidence. You can leverage the experience or confidence of your colleagues in order to help you build a stronger foundation for your business.

Limited Liability Partnership

Predictably, limited liability partnerships (or LLPs) are similar to their more basic counterpart. The key difference between a basic partnership and limited liability partnership lies in-- you guessed it-- liability. If you start a limited liability partnership, each partner's liability will be limited only to the funds they invest in the business.

Outside of this factor, LLPs are operated in much the same way as typical partnerships. They're often heavily profit-driven; this structure is especially favoured in the law and accountancy industries.

The Ideal Candidates

Anybody who's interested in beginning a partnership but feels hesitance when it comes to liability would be well-served by exploring their options with an LLP. Your member agreement offers you significant flexibility in how you structure liability and determine responsibilities; you can also leverage the benefits of a partnership without devoting time and stress to concerns about personal liability.

Private Limited Company

Private limited companies are their own separate legal entities. That means that, as far as the law is concerned, your business is entirely independent from you.

Private limited companies are the most popular business structure in the UK. Most business owners are drawn to the limited liability associated with formation. There are also a number of tax advantages that come along with operating as a limited company-- you're likely to pay less in taxes than sole traders, you can defer income from a high-tax rate year to a lower-tax rate one, etc.

The Ideal Candidates

Those who are looking to be saddled with very limited liability may be well-served by this structure. Your liability (as well as the liability of any shareholders) will be limited only to investments made and unpaid shares owned. If you don't want your personal assets entangled in your business's health, this is an excellent way to avoid that issue. Your personal assets will never be exposed in the event your business comes to an end.

Guarantee Company (Non-Profit)

Non-profits are another business structure which operate as independent legal entities from their owners. This presents a benefit to entrepreneurs who are hesitant to saddle themselves with significant liability or take on the debts of their business. They protect guarantors' (who pay set amounts of money towards company debts) personal finances and they're a great way to build trust between clients and investors.

Companies limited by guarantee do not have shareholders-- they have members instead. Generally, these members will be free to attend general meetings, vote on business decisions, and even appoint and remove directors. These individuals have ultimate control over the company.

The Ideal Candidates

Usually, companies limited by guarantee are formed by non-profit organization owners who are looking to obtain limited financial liability. Examples of these include a variety of clubs and membership organizations like sports associations, students' unions, and workers' co-ops. If you're hoping to start a business with the intent to raise money and promote the aims of your company, you'll be well-served by structuring as a guarantee company.

If you're considering taking the plunge and starting your own business, selecting the proper business structure for your needs is essential. The good news? You don't need to make these decisions on your own. In fact, you'll be well-served by partnering with a company formation service who can offer you valuable insight into the decision-making process.

Company formation services offer budding entrepreneurs a one-stop solution for the growing pains that come along with establishing and expanding a business. You'll be able to team up with a personal advisor who will guide you through company formation, accountancy processes, and even set up consultations with other company partners. For those struggling to make the final call before formation, these services offer a relief from pressure and the assistance you need to make the best decision for your future.

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