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Sept 07, #10

M

MindFull

Ton up Member
I have been trying to figure out this question for some time and I just can't get the answer. Help!

A trade creditor is owed £6,000 by a company that is in the process of being
liquidated. The company was financed by £1m of ordinary shares, £2m of preference
shares, £2.5m of retained earnings, £0.6m of secured debentures and £3.7m of other
loans, including the trade creditor’s balance.
The creditor hopes to recover 20% of the amount owed. How much would the
company’s assets have to realise in order for this to happen?
 
The secured debenture holders must be paid first, so the first £0.6m of assets are fully attributable to them. Assuming that all the other creditors rank equally, we must hope to realise enough further assets to repay 20% of the £3.7m of other loans. So, we need to realise £0.6m + 20% of £3.7m = £1.34m (Shareholders will be paid last!)
 
So easy

I am an idiot.... but I think where my prob. lied is that I thought that the 2.5m would be used to pay off the debentures, that is, the retained earnings... Could you address this please?

Thanks much.
 
The retained earnings are not assets. The retained earnings are one part of the shareholders ownership in the company and behind the other creditors in the queue for payment.
 
So in the event of a winding-up, the shareholder's reserves/retained earnings would only be used to pay th shareholders? I was just wondering since the notes usually say there isn't enough money left after paying creditors for the shareholders to receive any of their investment.


Thanks.
 
No, it isn't that the retained earnings are used just for the shareholders. As Walrus says, it's because the retained earnings aren't part of the assets - the retained earnings are one of the sources of finance. (One way of looking at this is that the retained earnings may well have been spent already to buy other assets like equipment or raw materials. If they've not been spent, there'll appear in "cash" in the balance sheet assets.)

If we consider the balance sheet equation, Assets = Capital + Liabilities, then the retained earnings are part of the Capital.

So the bottom of the balance sheet for the company in this question would look like:

Capital
£1m ordinary shares
£2m preference shares
£2.5m retained earnings

Liabilities
£0.6m secured debt
£3.7m unsecured

In the event of winding up, you'd see what assets the company had and use them to pay off in the order - secured liabs, unsecured liabs, preference shareholders, ordinary shareholders.

Hope this helps? Best wishes for the exam
Lynn
 
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