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Chapter 5: Sole Proprietorship

Most businesses a person deals with in a single day are owned by one individual. The chemist at the corner of the street, the tailor who takes measurements himself, the stationery shop near the school and the electrician who repairs a fan are all running enterprises that they own, finance and manage on their own account. Such a business is called a sole proprietorship, and it is the oldest and the most widely found form of business organisation in India. Before starting any business, a person must decide who will own it, who will supply the capital, who will take decisions and who will bear the loss if the venture fails. The sole proprietorship answers all four questions with one name — the proprietor. This gives the owner complete control and the whole of the profit, but it also leaves the owner alone with the risk, the debts and the limits of one person’s capital and ability. This chapter explains the meaning of sole proprietorship, its essential features, its merits and demerits, and the kinds of business for which it is best suited.

Figure

Fig. 5.0-1 — A Neighbourhood Shop Run By Its Owner Photograph of a small neighbourhood retail shop with the owner standing behind the counter attending to a customer.

5.1 What Sole Proprietorship Means

Every business must settle four questions before it begins to trade: who will own it, who will bring in the capital, who will take the decisions and who will bear the loss if it fails. The form of organisation a person chooses is simply the answer to these four questions. In the smallest and simplest form, all four answers are the same — one person.

Sole proprietorship, also called sole trade or sole tradership, is that form of business organisation which is owned, financed, managed and controlled by a single individual. That individual supplies the capital, takes every important decision, receives the whole of the profit and bears the whole of the loss. Because ownership and management rest in the same hands, the business needs no agreement with anyone and no approval from anyone before it acts.

NoteDefinition

Sole Proprietorship Sole proprietorship is a form of business organisation in which a single individual owns, finances, manages and controls the business, is entitled to all its profits and personally bears all its losses and risks.

The owner of such a business is called the sole trader, and is also described as the sole proprietor, the sole owner, the individual entrepreneur or the sole organiser. All these terms refer to the same person — the one individual in whom ownership, control and risk-bearing come together.

Owner And Business Are One

In law there is no distinction between a sole proprietorship and the person who runs it. The business has no separate legal existence of its own, so it cannot own property, sue or be sued in its own name. Its debts are the owner’s debts, and its income is taxed as the owner’s income.

This single point explains most of what follows in this chapter. Because the owner and the business are one, the owner alone enjoys the profit; and for the same reason, the owner’s private property can be reached by the creditors of the business if its own assets fall short.

Employing Others Does Not Change The Form

A sole trader may employ assistants, salesmen, a mechanic or an accountant, and the business remains a sole proprietorship. What defines the form is not the number of persons working in the business but the number of persons owning it. A tailoring unit with four employees is still a sole proprietorship if one person owns it, bears its risk and takes its decisions.

The scale of such a business, however, normally stays small. One person’s savings, borrowing capacity and managerial time set a natural limit on how far it can be expanded.

5.1.1 Definitions Of Sole Proprietorship

Writers on business organisation have defined the sole proprietorship in different words, but each definition fixes attention on the same central idea — one individual who owns the business, directs it and carries its risk.

Kimball and Kimball emphasise the proprietor’s freedom of action, describing the individual proprietor as the supreme judge of every matter relating to the business, restrained only by the general law of the land and by any special legislation affecting that particular trade.

C.W. Gerstenberg emphasises the proprietor’s position within the enterprise, describing the individual proprietorship as a business owned by an individual who is usually its manager as well as its owner, and who is therefore the pivot of the whole undertaking.

L.H. Haney emphasises risk-bearing, describing the individual entrepreneur form as an organisation at the head of which stands one individual who is responsible for it, who directs its operations and who alone runs the risk of failure.

Peterson and Plowman bring ownership and management together, describing sole proprietorship as a business unit whose ownership and management are vested in one person, who assumes all risks of loss and receives all profits from successful operation.

NoteDefinition

Sole Proprietorship — L.H. Haney The individual entrepreneur form of business organisation is an organisation at the head of which stands an individual who is responsible for it, who directs its operations, and who alone runs the risk of failure.

What The Definitions Have In Common

Read together, these definitions establish four elements that recur throughout the chapter.

  1. Single ownership — the capital is supplied by one person, whether from savings or from borrowings raised on personal credit.
  2. Single management and control — the same person takes decisions and supervises the work, so authority is never divided.
  3. Sole risk-bearing — the entire profit belongs to the owner and the entire loss falls on the owner.
  4. No separate legal entity — the business and the businessperson are treated as one, which is why the owner’s liability extends to private property.
NoteDefinition

Sole Proprietorship — Peterson And Plowman Sole proprietorship is a business unit whose ownership and management are vested in one person, who assumes all risks of loss or failure of the enterprise and receives all profits from its successful operation.

5.2 Features Of Sole Proprietorship

A form of business organisation is identified by its features, because those features decide how the business will be formed, how decisions will be taken and who will suffer if it fails. The features of sole proprietorship all follow from the one fact established in the previous section — a single individual owns the business, and the business has no legal existence apart from that individual.

The features may be grouped under three heads, as summarised in FC 5.1: those concerning ownership and capital, those concerning management and control, and those concerning risk and legal status.

Flowchart

FC 5.1 — Features Of Sole Proprietorship Features → Ownership And Capital, Management And Control, Risk And Legal Status; Ownership And Capital → Individual proprietorship, Sole ownership of capital, Small size of business; Management And Control → Sole management, Freedom in selection of trade, Secrecy, Personal relations, Discretionary start and end; Risk And Legal Status → Unlimited liability, No separate entity, Monopoly of profits, Freedom from legal formalities

Ownership And Capital
  1. Individual proprietorship — the business belongs to one person, who alone is responsible for all its affairs. Assistants and employees may be engaged, but the ultimate responsibility for every act of the business rests with the proprietor.
  2. Sole ownership of capital — the whole of the capital is arranged by the proprietor, from personal savings or from loans raised on personal credit and security. No outsider contributes capital as an owner, so no outsider can claim a share in the profits.
  3. Small size of business — the area of operation stays limited because capital and managerial time come from one source. A single person’s resources cannot support large-scale production or a wide market, so the firm normally serves a local or specialised demand.
Management And Control
  1. Sole management — the proprietor manages the business personally, and even when employees are appointed, the direction and supervision of their work remains with the proprietor. Authority is never divided, so orders never conflict.
  2. Freedom in selection of trade — the proprietor chooses the line of business without consulting anyone, and may change it when circumstances change, because no partner or shareholder has to agree to the change.
  3. Secrecy — business information stays with the proprietor. There are no partners to be informed and no accounts to be published, so trade secrets, sources of supply and margins need not be disclosed to competitors.
  4. Personal relations — the proprietor deals with customers, suppliers and employees directly. This direct contact makes it possible to learn customers’ tastes at first hand, which matters greatly in retail trade and in professional services.
  5. Discretionary start and end — the business may be commenced or wound up whenever the proprietor decides. Since no other owner’s consent is needed and few legal steps are involved, entry into and exit from the trade are both easy.

5.3 Merits Of Sole Proprietorship

The sole proprietorship survives alongside partnerships and large companies because, for a small business, undivided ownership is an advantage rather than a weakness. Where the capital needed is modest, the market is local and the work depends on the owner’s personal attention, the simplest form is also the most efficient one.

Each merit below arises from a feature already established — single ownership, single management, or the absence of legal formality.

Ease And Economy Of Operation
  1. Easy formation — no agreement has to be drawn up and no incorporation procedure has to be completed, so the business can be started as soon as the proprietor arranges the capital and the premises. This makes the form the natural choice for a first venture.
  2. Low cost of operation — there are no partners to be paid, no directors to be remunerated and no statutory publication of accounts, so establishment and administrative costs stay low. The savings are important when the volume of business is small.
  3. Economy in the use of resources — the proprietor bears every loss personally, and therefore watches waste, credit and stock more closely than a paid manager would. Ownership and supervision resting in the same hands is itself a form of cost control.
  4. Ease of dissolution — the business can be closed as easily as it was started, since only the proprietor’s decision is required. Capital locked in an unsuccessful venture can therefore be released quickly.

Freedom From Formalities And Freedom From Law A sole proprietorship needs no formation procedure, but it is not outside the law. The proprietor must still obtain trade licences, obey labour and tax law, and may not carry on a prohibited trade.

Speed And Flexibility
  1. Prompt decisions — the proprietor need not consult a partner, a board or a general body, so a decision can be taken and acted upon the same day. In a competitive market, the ability to respond quickly to a change in price or demand is a real commercial advantage.
  2. Flexibility — the line of goods, the pricing and the methods of work can all be altered when circumstances change, because only one person’s judgement has to be revised. A firm with several owners cannot change direction so easily.
  3. Secrecy — since accounts need not be published and no partner has a right to inspect them, business plans and sources of supply stay confidential. A new idea can be used before competitors learn of it.
Motivation, Credit And Goodwill
  1. Direct incentive to work — the whole of the profit belongs to the proprietor, so effort and reward are directly linked. Harder work and better service translate immediately into higher personal earnings.
  2. Personal contact with customers — dealing with customers directly allows the proprietor to learn their tastes, remember their preferences and adjust the stock accordingly. This builds goodwill and repeat custom, which a large impersonal firm finds harder to earn.
  3. Credit standing — because liability is unlimited, lenders can look to the proprietor’s private property as well as to the business assets. A proprietor of good repute can therefore obtain bank credit on reasonable terms, in spite of the small size of the firm.
  4. Benefit of inherited goodwill — where a business passes from parent to child, the successor inherits established customers, suppliers and trade knowledge, and is spared the difficulties of building a clientele afresh.
  5. Tax position — the proprietor is assessed as an individual, so the income of the business is taxed in the owner’s personal assessment and the exemptions and slab rates available to individuals apply. There is no separate levy on the business as an entity.

Personal Attention In Neighbourhood Retail A tailor who has stitched for the same families for years knows their measurements, preferences and delivery habits without keeping records of them. That knowledge is the proprietor’s own, cannot be transferred easily to a competitor, and is the reason customers return even when a larger store charges less.

Social Value Of The Form
  1. Wide distribution of ownership — because very little capital is needed, a large number of people can own businesses instead of a few owning very large ones. The form therefore checks the concentration of wealth and offers self-employment to those who cannot find salaried work.
  2. Employment and local service — small proprietary firms together employ a substantial number of people and supply goods and services in localities that large firms find unprofitable to serve. Their spread across small towns and villages gives them a social importance out of proportion to their individual size.

5.4 Demerits Of Sole Proprietorship

The merits of the form and its limitations come from the same source. One person owning the business gives speed, secrecy and the whole profit; the same one person owning the business sets a ceiling on capital, on managerial skill and on the life of the firm, and leaves private property exposed to business creditors.

These limitations decide the point at which a growing business must be converted into a partnership or a company.

Limitations Of Resources
  1. Limited capital — the funds available are confined to the proprietor’s own savings and to whatever can be borrowed on personal credit. Shares and debentures cannot be issued to the public, so a large or capital-intensive project is out of reach.
  2. Limited managerial ability — production, purchase, sales, accounts and staff must all be handled by one person, who is unlikely to be equally skilled in all of them. As the business grows, the areas the proprietor understands least become the areas where losses arise.
  3. Limited scope for expansion — since both capital and managerial time are fixed by one individual’s capacity, the firm can grow only up to a point. Beyond it, further growth requires either additional owners or the corporate form.
  4. Weak bargaining position — a small buyer cannot command the discounts, credit terms or priority in supply that a large buyer obtains, and a small seller cannot influence the market price. The proprietor is therefore at a disadvantage on both sides of the trade.

Lack Of Continuity And Ease Of Dissolution Ease of dissolution is a merit — the proprietor chooses to close the business. Lack of continuity is a demerit — the business ends on the owner’s death or incapacity, whether the owner wished it or not.

Risk Borne By One Person
  1. Unlimited liability — if the assets of the business cannot meet its debts, the creditors may proceed against the proprietor’s private property, including savings and a house held in the proprietor’s name. The risk of the business therefore extends to personal wealth, and this fear itself discourages proprietors from taking up ventures that would be profitable but risky.
  2. Lack of continuity — the business depends on the life and health of one person. Illness, an accident, insolvency or death interrupts it at once, and on the owner’s death it comes to an end unless an heir chooses to carry it on as a fresh proprietorship.
  3. Concentration of loss — just as the entire profit belongs to the proprietor, the entire loss falls on the proprietor. There is no partner to share a bad year, so a single failure can wipe out the savings of many good years.

Case 5.1 — When The Business Assets Fall Short Ravi Traders is a confectionery business owned by one person. After two years of losses the owner decides to close it. The firm owes a large sum to a supplier from whom goods were taken on credit, and the assets of the business are not sufficient to pay the debt in full. Q. State whether the supplier can recover the balance from the owner’s personal assets, and name the feature of sole proprietorship that decides the answer.

Limitations Of Judgement And Standing
  1. Hasty decisions — the speed that comes from consulting nobody also means that no one checks the proprietor’s judgement. A decision taken alone and in haste, on incomplete information, can prove costly, and there is no partner to point out the error before it is acted upon.
  2. Secrecy invites suspicion — since accounts are not published and information is not shared, suppliers and lenders cannot judge the firm’s true position. They may therefore hesitate to extend large credit, so the very secrecy that protects the business also restricts it.
  3. Easily imitated — the form requires no capital of consequence and no formalities, so a successful line of business is quickly copied by others in the same locality. Competition among small firms is intense and margins are thin.

One Illness, One Closed Shop A locality is served by a single repair workshop run by its owner. When the owner is hospitalised for a month, the shutter stays down, customers take their work elsewhere, and much of that custom does not return. No partner or co-owner exists to keep the business running in the meantime.

The weight of these limitations varies with the size of the firm. For a small local business they are tolerable, and the merits of the previous section outweigh them. For a business seeking scale, they are decisive.

Name one business in your locality that has grown too large to be run by one person, and state which limitation of sole proprietorship it would face first.

5.5 Suitability Of Sole Proprietorship

No form of organisation is best in itself. A form is suitable when its features match the requirements of the particular business, and the sole proprietorship suits businesses whose requirements are small in scale but high in personal attention.

The conditions of suitability follow directly from the merits and limitations already examined.

When The Form Is Suitable
  1. Small capital requirement — the business must be one that can be started with the savings and borrowing capacity of a single person, since no other source of ownership capital exists.
  2. Simple operations — where the work does not call for specialised technical or managerial skills in several fields, one person’s ability is sufficient to run it.
  3. Limited and local market — where customers are drawn from a locality, the proprietor can supervise the whole business personally and no wide sales organisation is needed.
  4. Personal attention to customers — where individual taste, fashion or trust decides the sale, direct dealing by the owner is an advantage that a larger firm cannot easily match.
  5. Need for quick decisions — where prices, supplies or fashions change rapidly, the ability to decide without consulting anyone keeps the business competitive.
  6. Low and manageable risk — since the loss falls on one person and liability is unlimited, the form suits ventures where the risk is small enough for one individual to bear.
Businesses Commonly Organised As Sole Proprietorships
  1. Retail trade of a local kind — grocery and provision shops, stationery shops, chemists, bakeries and vegetable and fruit sellers.
  2. Personal and repair services — tailoring units, salons, laundries, photocopy shops, cycle and mobile phone repair workshops.
  3. Professional practice — the clinic of a doctor, the chamber of a lawyer, the office of a chartered accountant, and coaching or tuition services, where the customer buys the skill of a named individual.
  4. Small manufacturing and craft units — bakery units, handloom and handicraft workshops and small food processing units that supply a local market.

Why A Clinic Stays A Proprietorship A patient chooses a clinic for the doctor rather than for the establishment. Capital needed is modest, decisions are taken by the practitioner alone, and the service cannot be delegated to others. The features of sole proprietorship match these requirements exactly, which is why professional practices rarely take a larger form.

When The Form Becomes Unsuitable

The same conditions read in reverse show when a proprietorship must give way to another form. Large capital requirements, heavy or long-term risk, a market spread over several regions, and work that needs specialists in production, finance and marketing all exceed what one owner can supply. At that stage the proprietor must admit partners or convert the business into a company, accepting shared control in exchange for greater resources and limited liability.

The position of the sole proprietorship on the main tests of a business organisation is consolidated in Table 5.1.

Table 5.1 — Sole Proprietorship At A Glance | Basis | Position In A Sole Proprietorship | |—|—| | Ownership | A single individual | | Formation | No incorporation; only trade licences and registrations | | Capital | Owner’s savings and personal borrowings | | Management and control | Wholly with the owner | | Decision making | Quick and independent | | Liability | Unlimited, extending to private property | | Profit and loss | Entire profit and entire loss belong to the owner | | Continuity | Depends on the life and capacity of the owner | | Suitable for | Small, local businesses needing personal attention |

Choose any two businesses you deal with regularly and state, with one reason each, whether a sole proprietorship is the suitable form for them.

5.6 Summary

  1. Sole proprietorship is the form of business organisation in which one individual owns, finances, manages and controls the business, takes the whole profit and bears the whole loss.
  2. The owner is called the sole trader, sole proprietor, sole owner or individual entrepreneur, and the law makes no distinction between the business and this individual.
  3. Employing assistants does not change the form, because what identifies a sole proprietorship is the number of persons owning the business, not the number working in it.
  4. Definitions by Kimball and Kimball, C.W. Gerstenberg, L.H. Haney and Peterson and Plowman agree on four elements:
  1. Single ownership — the capital comes from one person.
  2. Single management and control — decisions are taken by that same person.
  3. Sole risk-bearing — all profits and all losses belong to the owner.
  4. No separate legal entity — the business and the businessperson are one in law.
  1. The features of the form fall under three heads:
  1. Ownership and capital — individual proprietorship, sole ownership of capital, small size of business.
  2. Management and control — sole management, freedom in selection of trade, secrecy, personal relations, discretionary start and end.
  3. Risk and legal status — freedom from legal formalities, no separate entity, unlimited liability, monopoly of profits.
  1. Unlimited liability means the owner’s private property may be used to pay business debts when the assets of the business are insufficient.
  2. The merits of the form include easy formation, low cost of operation, economy in the use of resources and ease of dissolution.
  3. Undivided ownership also gives prompt decisions, flexibility in changing the line of business, and secrecy of accounts and plans.
  4. Further merits are the direct incentive to work, personal contact with customers, credit standing supported by private property, inherited goodwill and assessment to tax as an individual.
  5. Socially, the form spreads ownership widely, checks the concentration of wealth, provides self-employment and serves localities that large firms do not find profitable.
  6. Its limitations of resources are limited capital, limited managerial ability, limited scope for expansion and a weak bargaining position as buyer and as seller.
  7. Its limitations of risk are unlimited liability, lack of continuity on the owner’s death or illness, and concentration of the entire loss on one person.
  8. Deciding alone can lead to hasty decisions, secrecy can make suppliers and lenders suspicious, and the form is easily imitated, so competition among small firms is intense.
  9. The form is suitable where capital needed is small, operations are simple, the market is local, personal attention decides the sale, decisions must be quick and risk is manageable.
  10. Local retail trade, personal and repair services, professional practice and small craft or manufacturing units are commonly organised as sole proprietorships.
  11. When capital requirements, risk, market spread or the need for specialists exceed what one owner can supply, the business must be converted into a partnership or a company.

5.7 Key Terms

  1. Sole proprietorship A form of business organisation in which a single individual owns, finances, manages and controls the business, is entitled to all its profits and personally bears all its losses and risks.
  2. Sole trader The single individual who owns and runs a sole proprietorship; also called the sole proprietor, sole owner or individual entrepreneur.
  3. Unlimited liability Liability that is not restricted to the amount invested in the business, so that the owner’s private property may be used to pay business debts when the assets of the business are insufficient.

5.8 Points To Ponder

  1. Unlimited liability is treated as the heaviest drawback of sole proprietorship, yet it is also what allows a small proprietor to obtain bank credit. Is it, on balance, a weakness of the form or a source of strength?
  2. Secrecy protects a proprietor from competitors but makes suppliers and lenders cautious about extending credit. At what point does the cost of withholding information exceed the benefit of keeping it?
  3. A proprietor whose business is growing can either appoint professional managers or convert the firm into a partnership or company. Which course preserves more of what made the business successful in the first place?
  4. Sole proprietorships are easy to start and equally easy to imitate. Does this openness serve customers well by keeping competition alive, or does it keep small firms permanently unprofitable?
  5. The form is said to spread ownership widely and check the concentration of wealth. Does the large number of very small firms in India indicate a healthy business environment, or a shortage of the capital and skills needed to build larger ones?
  6. Speed of decision is listed as a merit and hasty decision as a demerit, though both arise from the absence of consultation. How can a proprietor keep the first without inviting the second?

5.9 Objective Questions

  1. A sole proprietorship is best identified by the fact that: [1]
  1. only one person works in the business
  2. only one person owns the business and bears its risk
  3. the business is registered with the Registrar of Companies
  4. the business employs no more than ten persons
  1. There are two statements given below, marked as Assertion (A) and Reason (R). Read the statements and choose the correct option. [1] Assertion (A): The private property of a sole proprietor may be used to pay the debts of the business. Reason (R): A sole proprietorship has no legal existence separate from its owner.
  1. Both (A) and (R) are true, and (R) is the correct explanation of (A).
  2. Both (A) and (R) are true, but (R) is not the correct explanation of (A).
    1. is true, but (R) is false.
    1. is false, but (R) is true.
  1. State whether the following statement is true or false: A sole proprietorship needs no formation procedure, and therefore its owner needs no trade licence or tax registration of any kind. [1]
  2. Match Column A with Column B and choose the correct option. [1]
  1. Sole ownership of capital
  2. Unlimited liability
  3. Discretionary start and end
  4. Secrecy
  1. Private property may be used to settle business debts
  2. Accounts need not be published to anyone
  3. Funds come from the owner’s savings and personal borrowings
  4. The business may be closed whenever the owner decides
  1. (i)–(C), (ii)–(A), (iii)–(D), (iv)–(B)
  2. (i)–(A), (ii)–(C), (iii)–(B), (iv)–(D)
  3. (i)–(C), (ii)–(D), (iii)–(A), (iv)–(B)
  4. (i)–(B), (ii)–(A), (iii)–(D), (iv)–(C)
  1. Fill in the blank: A sole proprietorship comes to an end on the death of its owner because the form lacks __________ succession. [1]

5.10 Check Your Concepts

  1. Define sole proprietorship and state any one feature that follows from the absence of a separate legal entity. [2]
  2. A shopkeeper says that appointing three salesmen has turned the shop into a partnership. State whether this is correct and give reasons for your answer. [3]
  3. Distinguish between ease of dissolution and lack of continuity in a sole proprietorship. [3]
  4. Explain, with an example, why quick decision-making is treated as a merit of sole proprietorship and hasty decision-making as a demerit, although both arise from the same cause. [4]
  5. ‘Sole proprietorship is the most suitable form of business organisation for every small business.’ Evaluate this claim, examining the conditions under which the form is suitable and the limitations that decide when it must be given up. [6]

5.11 Case-Based Questions

  1. Nandini owns a bakery that she started with her savings and a loan from her bank. She buys the material, supervises the baking, deals with customers herself and keeps her recipes and margins to herself. Her cakes have become popular in three neighbouring localities, and traders there now want regular supplies. To meet this demand she must buy a large oven and appoint a supervisor, but her savings are exhausted and the bank is unwilling to lend her any further amount.
  1. Identify the form of business organisation Nandini has adopted and state two of its features shown in the situation above. [2]
  2. Name the limitation of this form that is preventing her expansion, and state one step she may take to overcome it. [2]