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THE LIBRARY

OF

THE UNIVERSITY
OF CALIFORNIA

LOS ANGELES



SCHOOL OF LAW



BUSINESS FINANCE

A Practical Study of Financial Manage-
ment in Private Business Concerns



BY

WILLIAM H. LOUGH

President, Business Training Corporation,
New York City; formerly Professor of
Finance, New York University School of
Commerce, Accounts and Finance; Author
of "Corporation Finance," "Lectures on
Panics and Depressions," "Banking Oppor-
tunities in South America," etc.




( Sixth Printing )
NEW YORK

THE RONALD PRESS COMPANY
1920



8



193,0

Copyright, 1917, by
THE RONALD PRESS COMPANY



PREFACE

This book, as its name indicates, is concerned with the
cvery-day financial problems of the private business concern.
The point of view taken throughout is that of an organizer
or financial manager of an enterprise. While the book deals
primarily with business conditions and financial practice in
the United States, it includes many references also to the ex-
perience and practice of other countries which may yield
suggestions of value to American business men.

Many social and economic questions are necessarily
touched upon incidentally. These questions, however, in the
author's judgment, belong to a separate field of study; no
attempt is made, therefore, to discuss them at any length.

The subject matter of the book falls naturally into five
distinct parts:

Part I begins with a brief exposition of the essential
principles of all sound financing; it is devoted for the
most part to a description of the different forms of finan-
cial organization of business enterprises, taking up in turn
the individual proprietorship, the firm or partnership, and
the corporation.

Part II discusses the various forms of security issues
and the manner in which they may be combined and or-
ganized as determined by the basis of capitalization of the
particular enterprise.

Part III treats of the methods of raising capital
through the, sale of securities and the usual forms of
promotion and underwriting.

Part IV deals with efficient financial management ; how
capital funds are invested; how the amount required for

working capital is ascertained ; the proper management of

ft
111



687167



i v PREFACE

capital and income through budgets; and some of the
financial standards which should be kept in view.

Part V treats of financial mismanagement and irregu-
larities, and of the processes of reorganization.

This very brief review is enough to make clear the main
purposes of the book and the groups of business men to whom
it is designed to prove useful.

The first group, whom the author has had constantly in
mind, consists of organizers, directors, and executive officers
of business concerns of all classes. It is hoped that they will
obtain from the book many helpful suggestions which they
can put to practical use.

The second group consists of bankers, bond dealers, and
other financial men who are continually investigating and
criticizing the financial management of enterprises.

There is a third group, composed of engineers, lawyers,
accountants, and other professional men, who are frequently
called upon to advise as to financial questions, although they
are not necessarily well informed on these subjects.

The previous literature on the subject has been so scanty
that the book to a considerable extent necessarily breaks fresh
ground ; and this must be the author's excuse if sometimes the
treatment of a topic seems to be incomplete. This remark
applies with special force to the chapter on "Financial Stan-
dards" a subject to which a great amount of research could
profitably be devoted.

WILLIAM H. LOUGH
New York City,

April 9, 1917



CONTENTS



PART I FINANCE AND BUSINESS

Chapter Page

I PRINCIPLES OF FINANCING i

Scope of Subject

Unskillful Business Financing

Financing and Accounting

Public Financing and Business Financing

Simplicity of Business Finance

Borrowing Money

Permanent and Transient Investments

Application of Income

Elementary Rules of Financing

II FORMS OF BUSINESS ENTERPRISES . . .11

Basic Types of Business Organization

Sole Proprietorship

The Partnership

Disadvantages of the Partnership

The Corporation

Limited Partnerships

Joint-Stock Companies

Associations under Deeds of Trust

Business Organization Under the Latin Law

Business Organization Under the German Law

III THE CORPORATION 25

Origin of Corporations
Fiction of Corporate Entity
Grant of Power by the State
Special Charters
The Corporate Name
The Corporate Purposes
Classes of Stock
The Principal Business Office
Operation in Other Jurisdictions
Operation in Foreign Countries
Internal Regulations and By-Laws
Rights and Duties of Shareholders
V



vi CONTENTS

Chapter Page

The American Practice
The English Practice
Rights and Duties of Directors
Corporate Officers and Directors
The "Clayton Bill"
"Ornamental Directors"
Compensation of Directors
Legal Status of Directors
Contracts with Directors

IV THE CORPORATE FORM ADVANTAGES AND DIS-
ADVANTAGES 45

Corporations in Modern Business

The Number of Small Corporations

The Army of Stockholders

Types of Business Corporations

Close and Open Corporations

Holding Companies

The Illegal Combination

Legality of Holding Companies

Combination of Non-Competitive Companies

The Use of Subsidiary Corporations

Advantages of Subsidiary Corporations

Advantages of Corporate Form

Advantage of Partnership Incorporation

Advantage of Continuity of Ownership

Disadvantages of the Corporate Form

Efficiency of Corporate Organization

Insolvency of the Northern Pacific

Management of the Colorado Fuel and Iron Company

Avoidance of Centralization

Duties of Directors



PART II CAPITAL
V OWNED CAPITAL 64

Owned and Borrowed Capital .

Stocks and Shaies

Transfer of Stock

A Corporation Dealing in Its Own Stock

"Common Stock" or "Ordinary Shares"



CONTENTS Vli

Chapter Page

Preferred Shares

Origin and Uses of Preferred Shares
Protection of Preferred Shares
Dividend Rights of Preferred Shares
Redemption of Preferred Shares
General Characteristics of Preferred Shares
Special Forms of Shares
Certificates of Stock
Par Value of Shares

Issue of Shares Full-Paid and Partly Paid Shares
Bonus Shares

Watered Shares Overcapitalization
Shares Without Par Value
Methods of Voting
Cumulative Voting
Stockholders' Meetings
Voting Trust

VI BORROWED CAPITAL SHORT-TERM . . . 105

Advantages of Borrowing

Proportions of Borrowed Capital

Forms of Borrowing

Trade Credit

Bank Credit

Bank Collateral

Factors Considered by Banks in Making Loans

Short-Term Notes Sold to the Public

VII BORROWED CAPITAL LONG-TERM . . .130

Bonds and Mortgages

Corporate Deeds of Trust

Corporate Bonds

Mortgage Bonds

Ratio of Mortgage to Value

Equipment Trust Bonds

Collateral Trust Bonds

Debenture Bonds

Income Bonds

Convertible and Participating Bonds

Sinking Funds

A Novel Proposal

Other Methods of Safeguarding Bonds



v iii CONTENTS

Chapter Page

VIII BASIS OF CAPITALIZATION 172

Definitions

Three Bases of Capitalization

Investment as a Basis of Capitalization

Capitalization of Initial Expenses and Losses

Capitalization of Earning Power

Estimates of Earning Power

Adjusting Capitalization to Assets

Valuation of Good-will

Recapitalization by Stock Dividends

Capitalization of Public Service Companies



PART III SECURING CAPITAL
IX SOURCES OF CAPITAL FUNDS . . . .201

Capital Funds

The Investing Public

Banks and Institutions

Investment Associations

Speculative Public

Wide Distribution of Shares

Selling Shares of Smaller Corporations

Adaptation of Securities to Market

Earnings and Security Issues

Effect of Limitation to Common Stock

Adequate Income for Common Stock Dividends

Assets and Security Issues

Special Provisions and Forms of Securities

Incorporating a Partnership

Financial Plan for a Railroad

Financing an Advertising Agency

Simplicity Desirable

X PROMOTION 229

Three Steps in Promotion
Stages of Investigation
Thoroughness in Investigation
Preliminary Analysis
Investing Upon an Uncertainty



CONTENTS IX

Chapter Page

Scope of Investigation
A Simple Example
A Complex Instance
"Assembling" a Proposition
Protection of Promoter
Purchase Outright
Preliminary Financing
Foresight in Providing Funds
Working Capital Required

XI THE PROMOTER 250

Professional Promoters
Engineering Firms as Promoters
Business Executives as Promoters
The Promoter's Financial Plan
Promoters' Legal Status
Promotion Risks
Promoters' Profits
Illustrative Instances

XII PROMOTING COMBINATIONS .... 265

Development of Industrial Combinations

Fields for Combinations

Difficulties in Forming a Combination

Preliminary Investigation

Basis of Combination

Typical English Combinations

Consolidations

Analysis of a Small Combination

Forming a Combination to Secure Control

Making Combinations Successful

XIII SELLING SECURITIES DIRECT .... 291

Four Methods of Selling Securities
Establishing Cordial Relations with Shareholders
Establishing Cordial Relations with Customers and

Employees

Grant of Subscription Privileges or "Rights"
Objections to Subscription Privileges
Figuring the Value of a "Right"
Making Use of a "Right"



x CONTENTS

Chapter Page

Selling at Auction
Finding Prospective Buyers
The Prospectus
Limitations of Direct Sale

XIV SELLING SECURITIES THROUGH DEALERS . 319

Classes of Security Merchants

Handling an Issue

Obligation of the Brokerage House

Limitation of Sale Through Security Merchants

Requirements of the Security Merchants

Stock Exchange Methods

Importance of Speculative Dealings

Making a Market

Limitations of Sale Through Stock Exchanges

XV UNDERWRITING 339

Origin of Underwriting

Importance of Underwriting in Present-Day Financing

The Underwriting Syndicate

Community of Interest Among Underwriting Houses

Syndicate Agreements

Speculative Underwriting



PART IV INTERNAL FINANCIAL MANAGEMENT
XVI INVESTMENT OF CAPITAL FUNDS . . . 355

Estimating Capital Requirements

Fixed Capital and Working Capital

Necessity for Adequate Working Capital

Some Factors That Affect Working Capital

Figuring Fixed Capital Requirements

Investing Capital in Extensions

Calculating the Extension of Capital for a Bank

Investing Capital in Betterments

Investing Capital in Side Lines

Investing Capital in Securities

Relative Amounts of Fixed and Working Capital



CONTENTS



XI



Chapter Page

XVII CALCULATING REQUIREMENTS FOR WORKING

CAPITAL 380

Factors to Be Considered

Length of Period of Manufacture

Terms of Purchase

Terms of Sale

Financing Instalment Sales

Working Capital Requirements for Instalment Selling

Converting Working Assets into Cash

An Unusual Problem

Working Capital to Provide for Seasonal Variations

Month-by-Month Calculations

XVIII DETERMINATION OF NET INCOME . . .415

Formula for Income

Honesty in Stating Gross Earnings

Operating Expenses and Deductions

Reserves

Operating Expenses and Betterments

Is Concealment of Betterment Expenditures Advisable?

Two Classes of Betterments



XIX DIVIDENDS



435



Net Income and Dividends

Average Rates of Dividends

Percentages of Earnings Devoted to Dividends

Regularity of Dividends Desirable

Variability of Profits

Rule for Maintaining Regularity of Dividend Rate

Policies of Important Companies

Paying Dividends from Accumulated Surplus

Cash Requirements for Dividends

Paying Dividends with Borrowed Cash

Effects of Lack of Prudence in Paying Dividends

Scrip Dividends

Stock Dividends

Legal Rules Affecting Dividends



XX SURPLUS



465



Surplus Reserve and Surplus Fund
Five Sources of Surplus



Xll



CONTENTS



Chapter



Accumulating Surplus
Policies of Various Companies
"Rainy-Day Funds"
Surplus as a Source of Capital
Hidden Surpluses

XXI BUDGETS

Nature and Types of Budgets

Use of Budgets

Objections to the Use of Budgets

Necessity for Continual Revision

Income Basis vs. Cash Basis

Income Budgets

Cash Budgets

A Manufacturer's Methods

XXII FINANCIAL STANDARDS

Need for Standards

Relation of Working Capital to Total Capital
Cash and Cash Resources
Turnover
Operating Ratios

Stock and Bond Issues in Relation to Gross Earnings
A Comparative Study-
Analysis Based on Financial Standards



Page



482



500



PART V FINANCIAL ABUSES AND
INVOLVEMENTS

XXIII EXPLOITATION BY OFFICERS

Exploitation Differs from Fraud

The Corporate Form Favors Exploitation

Petty Abuses by Subordinate Officers

Exorbitant Salaries

Contracts That Benefit Officers

Divergence of Business to Other Companies

"Unloading" and Securing Control

Misuse of Inside Information

Is Exploitation a Common Evil?

Exploitation in Other Countries



525



CONTENTS xiii

Chapter Page

XXIV EXPLOITATION BY DIRECTORS AND MAJORITY

SHAREHOLDERS 546

Enlarging the Circle of "Insiders"

Juggling Accounts

International Cotton Mills Corporation Case

Baltimore and Ohio Railroad Case

Atchison, Topeka and Santa Fe Case

Misleading Statements

Ethical Standards for Directors

Should Directors Be Compensated?

New Haven Railroad Case

Westchester Railroad Case

Purchase of Transportation Companies

"Squeezing" the Minority Stockholders

Exploiting Creditors

Preventives of Exploitation

Integrity of Directors

Special Provisions in Charter

The Power of Publicity

Exploitation Condemned



XXV INSOLVENCY AND RECEIVERSHIP . . -573

Two Types of Insolvency

Economic Insolvency

Technical or Financial Insolvency

Causes of Insolvency

Lack of Working Capital

Anxiety to Pay Dividends

Unfavorable Market Conditions

Methods of Procedure in Case of Insolvency

Readjustment of Claims

Origin and Nature of Receivership

Conflicting Receivership

Dissolution of Insolvent Corporations

Voluntary Dissolution

Instances of Voluntary Dissolution

Origin and Nature of Bankruptcy

Two Kinds of Bankruptcy

Receivers' Powers and Duties

Customary Results of Receivership



xi v CONTENTS

Chapter Page

XXVI REORGANIZATION 593

Purpose of Reorganization

Conflicts of Interests in Reorganization

Formation of Committees

Procedure in Reorganization

Raising Fresh Capital

Reducing Fixed Charges

Effect on Financial Structure

The Claflin Reorganization

Reorganizations for Special Purposes

Reorganization to Secure Control



BUSINESS FINANCE



Part I Finance and Business Organization

CHAPTER I
PRINCIPLES OF FINANCING

Scope of Subject

In this volume is considered the subject of securing and
handling money and credit for business enterprises. If these
terms were used with strict accuracy, the statement might be
shortened by leaving out the reference to money; for, after
all, credit in one form or another is almost the only element
with which we have to deal. But it is not necessary here to
enlarge upon these technical limitations.

Financing deals, first, with the raising of the initial capital
needed for business enterprises, what securities to issue, how
and to whom they should be sold, how best to utilize the
funds thus secured, together with their proper apportion-
ment for plant, equipment, and working capital ; second, with
the accurate determination of profits and their allocation to
dividends, surplus, sinking fund and reserves, and the en-
largement of capital permanently invested. It is concerned
with the forecasting of business development and resulting
financial needs and with provision for the business equivalent
of a "rainy day."

Unskilful Business Financing

Financing is, perhaps, the least understood subject in the
field of business, not even excepting accounting. A great

I



2 FINANCE AND BUSINESS ORGANIZATION

many men have proved themselves able and successful as
producers, organizers, and sellers, but have failed utterly in
handling their financial problems.

A conspicuous example was the late Mr. George Westing-
house, the brilliant inventor, organizer, and salesman who
founded the Westinghouse Electric and Manufacturing Com-
pany, the Westinghouse Air Brake Company, and other en-
terprises. Mr. Westinghouse made a success of every busi-
ness enterprise he touched except in so far as financing was
concerned. He apparently was not familiar with financial
methods and did not possess the foresight to keep his enter-
prises properly provided with cash as they progressed. Con-
sequently, he was twice faced with serious embarrassment
and in the end was compelled to relinquish the management
of the Westinghouse Electric and Manufacturing Company.

This case is not an uncommon one. In fact, it is quite
generally true that men of an optimistic, emotional turn of
mind who make good as producers and salesmen are just the
men who deceive themselves as to their own financial affairs
and often wreck a promising business on some financial reef.

It is surprising to find how many directors of important
corporations give insufficient attention to the basic financial
problems of corporate business. Frequently insolvency, which
should have been clearly foreseen, comes upon a board of
directors when they fancy their company to be at the height
of prosperity. This was true, for instance, of the insolvencies
during recent years of the National Cordage Company, the
American Malting Company, the National Asphalt Company,
the United States Realty Company, the New England Cotton
Yarn Company, and the Westinghouse Electric and Manu-
facturing Company.

Among smaller concerns the amount of ignorance regard-
ing financial management is even greater. Every experienced
business man probably has observed instances where profitable



PRINCIPLES OF FINANCING -r

o

enterprises were half developed and then abandoned for lack
of funds, when, in nine cases out of ten, the whole financial
process might have been figured out in advance and the neces-
sary funds raised with little difficulty. Instead, the enterprise
too often drags out a painful existence for a few months or
a few years, eats up the owner's capital, and at the end leaves
him a poorer, but not always a wiser, man.

Financing and Accounting

Poor financing is apt to be combined with poor account-
ing; and in that case the unfortunate owner cannot enjoy
even the empty satisfaction of a post-mortem diagnosis.

This brings up a question on which there has been much
confusion of thought the question as to the dividing line
between the subject of financing and the subject of account-
ing. It is not purely an academic question, for in many busi-
ness concerns the head of the accounting department and the
head of the financial department are continually treading on
each other's toes. Or, a still worse thing happens; the two
offices are combined under the management of one person.

There is undoubtedly a twilight zone between the two
subjects. When we come to discuss rates of depreciation,
sinking fund requirements, valuation of good-will, and the
like, we shall be in constant danger of trespassing into ac-
counting territory; while, on the other hand, our friends the
accountants, especially public accountants, have not hesitated
to make many bold forays into financial fields. Frequently
they are called upon to advise their clients as to securing
bank loans, the proper types of bonds and shares to issue, the
proper investment of capital funds, the declaration of divi-
dends, and so on. However, bankers, treasurers of corpora-
tions, and finance committees are becoming more and more
successful in repelling these incursions, thus restricting the
accountant to his proper activities.



4 FINANCE AND BUSINESS ORGANIZATION

We need not enter into the technicalities of the friendly
controversy. A broad distinction, however, between the two
fields of work and study may easily be made. Accounting,
properly speaking, deals with recording and analyzing results
that have been achieved ; and its growing value and popularity
is due to the general recognition that the conclusions drawn
by skilled accountants may profitably be used as a foundation
for future action.

Financing, on the other hand, deals not with recording
and analyzing but with getting positive results; how to raise
money for various business enterprises; what securities to
issue ; to whom they should be sold ; and how to use the pro-
ceeds to the best advantage for the promotion of the business.
These are some of the typical problems clearly outside the
scope of accounting which are discussed in this volume.

Two sister subjects in the field of finance are investing and
banking. Investing deals with the process of supplying capital
to business and public undertakings for their permanent use,
that is, as original investments or for long-term loans. Bank-
ing deals with the process of supplying capital to these enter-
prises for their temporary use, that is, for short-term loans
exclusively. Both of these processes are referred to frequently
but they are of so much importance that they will be treated
separately. (See Chapters V, VI.) It may be noted that
both investing and banking deal with supplying credit, while
financing deals with obtaining and using credit. The same
problem is involved in both but is treated from different points
of view.

Public Financing and Business Financing

Another cognate subject, which is, however, outside the
scope of this book, is public financing, which deals with the
securing and handling of money and credit for governments-
national, state, and municipal.



PRINCIPLES OF FINANCING 5

Public financing has been much studied and written about ;
many valuable books have been published on such subjects
as taxation, governmental loans and their repayment, regula-
tion of governmental expenditures, and the like. Business
financing, on the other hand, has been surprisingly neglected ;
there are only about a dozen books and a few magazine ar-
ticles devoted wholly to this subject, though, of course, a
great deal of valuable information may be gleaned from mis-
cellaneous publications.

Yet the relative importance of the two subjects public
financing and business financing seems to be in inverse ratio
to the amount of study that has been given to each.

In 1912, according to the United States Census, the total
value of all the property existing in the United States was
approximately $187,000,000,000, of which $12,000,000,000
or 7% was exempt from taxation and $175,000,000,000
or 93% was taxable. Making reasonable allowances for the
property of religious, educational, and philanthropic institu-
tions in the tax-exempted classification, there remains only
3% to $% of the wealth of the United States that is directly
owned by national, state, and municipal governments. Against
this there is 93% owned and managed by individuals, firms,
or corporations. On its face the comparison indicates that
the neglected subject of business financing is worthy of
thorough and careful study.

There are probably two chief reasons, both inadequate,
why business financing has been comparatively overlooked.
One is the false notion, prevalent until recent years, that
private business is a simple activity unworthy of serious con-
sideration by intellectual men. Another reason is that data
concerning methods of business financing methods are not
conveniently assembled in volumes or in reports or statistics,
but must be gathered, in large part, at first hand from active
business men and from general business experience. As time



6 FINAXCE AND BUSINESS ORGANIZATION

goes on, the subject will doubtless be more fully investigated
and more information will be made available.

It will become evident as we proceed that financing is
related also to other business subjects, such as production,
selling, organization, etc. ; but there is no confusion in its
relation to these subjects and no necessity for explanation.

Simplicity of Business Finance

It is popularly supposed that many difficulties are en-
countered in solving the problems of business finance. One
writer even has defined the science of business finance as "the
modern black art," as if it were something mysterious and
uncanny. Yet, whatever may be said of the difficulties per-
taining to actual practice, the essential principles of business
finance are simple and can be readily understood by anyone.
This can be illustrated by the close analogy existing between
the financial problems of the business enterprise and the finan-
cial problems encountered by the ordinary individual in his
daily life.

The individual possesses both tangible and intangible



Online LibraryWilliam H. (William Henry) LoughBusiness finance, a practical study of financial management in private business concerns → online text (page 1 of 49)