William H. (William Henry) Lough.

Corporation finance; an exposition of the principles and methods governing the promotion, organization and management of modern corporations online

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an office building or the construction of a railroad. In
such cases the installments may be certain definite per-
centages due at days fixed in advance, say 10 per cent
when the corporation is organized, 25 per cent at the
expiration of three months, 25 per cent at the end of six
months, 20 per cent at the end of nine months, and the
remaining 20 per cent at the end of a year. In this way
the sale of securities is facilitated, because buyers prefer
usually to pay in installments, and the corporation gets
its funds as needed.

The case is quite different, however, when the total
amount of capital funds needed cannot be foretold. A
corporation may be formed, for instance, to open up a
mine or construct a tunnel or start a magazine. No-
body can foresee absolutely what obstacles the under-
ground work of the mine or tunnel will encounter, or


how quickly the magazine will "take" with the reading
public. The promoter of such an enterprise, if he is
honest with himself, will recognize that the corporation
perhaps may need less and probably will need a great
deal more capital funds than he anticipates. In order
to meet this situation he will, if he can, induce people to
subscribe capital funds to an amount greater than will
probably be needed, issue part-paid stock when install-
ments to a certain amount, say 50 per cent, have been
paid and make the rest of the installments payable at
the option of the corporation. Thus the corporation
can get all the funds it needs and at the same time does
not have to carry large sums for which it has no partic-
ular use. This is the ideal arrangement for such a

155. Disadvantages of this method. — Unfortunately
this plan does not appeal to the average stockholder.
He does not like the idea of being liable at all times for
the unpaid installments, particularly as the calls for
additional payments in many such enterprises are apt to
come during periods of financial distress at the very
time when it will be extremely disagreeable for him to
meet them. Moreover, in large corporations such an
arrangement gives to the managers of the corporation
an opportunity for manipulation that they are not al-
ways virtuous enough to resist. Take the case, for ex-
ample, of a well-known street railway company, which
may be recognized by some of our readers, but whose
name it would be improper to give in this connection:
This company has a very large amount of part-paid
stock outstanding, the remaining installments being due
and payable at the option of the board of directors. It
is strongly suspected that the board on several occasions
have agreed among themselves in advance to issue a call


for an installment and have thus given themselves plenty
of time to accumulate cash. Then the call has been
issued and the installment made payable at a very early
date, so as to make it difficult for, most of the stock-
holders to meet the call. The result naturally has been
in each instance that considerable amounts of the part-
paid stock were thrown on the market and bought up at
bargain prices by the directors and their friends. With
the funds received from the installment the corporation
has been in position to put its property in good condition
and show excellent earnings for a year or two, thus al-
lowing the directors to sell stock at high prices. After
it was distributed the directors have issued another call
and have repeated the milking process. Experiences
like this have made buyers of securities very cautious in
the purchase of part-paid stock. Generally speaking, it
is a difficult thing to sell any stock that is not labeled
"full paid and non-assessable."

156. Other possible methods. — It follows that the
managers of a corporation, the needs of which for capi-
tal funds cannot be estimated in advance, are driven to
take one of two courses : either they must sell at the be-
ginning a far greater amount of securities than will
probably prove necessary, and put their idle funds to
some use outside the original purpose of the corporation,
or else they must trust to luck that they will be able to sell
more securities when additional capital funds are needed.
Neither one of these alternatives is free from serious

Here, then, is the first great problem in connection
with the investment of capital funds, that of getting the
funds when and if they prove to be needed. If that
problem is not solved in just the right manner, either
the corporation will have more funds on hand than it


needs and its rate of profits on stock will thereby be
diminished, or else it will not have enough funds and its
development will thereby be checked.

157. How much shall he invested in fixed capital? —
The next question to consider is, What proportion of the
capital funds shall be put into "fixed" and what into
"working" capital? The distinctions between fixed,
semi-fixed, current and quick assets were discussed in
Chapter VII. The fixed and semi-fixed assets to-
gether — those assets, in other words, which cannot be
readily converted into cash — constitute the corporation's
fixed capital. Working capital is somewhat different.
It consists, not of the current assets, but of the difference
between current assets and current obligations. In other
words, it consists of that amount of current assets which
is not furnished by trade and other short-time creditors
and by temporary bank loans.

The amount of fixed capital required by any corpora-
tion depends, of course, on the nature of its operations.
Industrial and mining corporations must have machin-
ery; railroad companies must have track and rolling
stock; trading companies must have office furniture be-
fore they can start business. The necessary total of
fixed capital is not always so great as it appears to an
outsider, for the reason that in most enterprises land,
buildings and even machinery can be rented to better
advantage than they can be bought. Accountants rec-
ognize this fact and are in the habit, in estimating the
true cost of production in a manufacturing establish-
ment, of charging an estimated rent for the land and
buildings even though they be owned in fee by the
corporation. It is well for corporation managers to
consider this possibility, especially in starting a new


enterprise, and where possible avoid the investment of
large sums in fixed assets until after the success of the
enterprise is assured.

One of the characteristics of fixed capital is that, al-
though it may be essential and valuable to the corpora-
tion which owns it, it is likely to have very little value
if put on the market for sale. Its value remains, in
other words, only so long as the concern is "going."
Therefore, the smaller the proportion of a corporation's
capital invested in fixed assets, the better off it is in case
of failure or bankruptcy.

158. Forms of working capital. — Working capital
may take any or all of four forms :

(1) Cash, either on hand or in banks.

(2) Bills and accounts receivable.

(3) Raw materials and finished products in stock.

(4) Securities of other corporations held, not for
control, but for temporary investment.

As an illustration take the following table, which
shows the current assets and current liabilities of the
United States Rubber Company for the fiscal year ended
March 31, 1908, compared with the preceding year and
the working capital, or excess current assets over current
liabihtles :


1907 1908

Inventories $18,404,726 $13,533,169

Cash 2,061,401 2,723,380

Bills receivable 3,681,126 994,250

Accounts receivable 8,687,631 8,494,234

Totals $32,834,884 $25,745,033

IV— 19



Loans and notes payable $ 6,821,077 $ 2,4i4<0,077

Accounts payable 737,384( 362,634

Due General Rubber Co 7,269,441 7,164,111

Reserve for discount 872,989 874,735

Totals $15,700,891 $10,841,557

Working capital $17,133,993 $14,903,476

159. How much working capital shall he carried? —
The amount of actual cash needed by a corporation
varies with the size of its pay-roll and other current
demands for cash, with the amount and character of its
accounts payable considered in connection with its ac-
counts receivable, with the discounts that it may obtain
on purchases by making cash payments, and with its
facilities for securing temporary loans. The force of
these considerations must be estimated by the corpora-
tion managers. Obviously there is a waste in carrying
unnecessarily large bank balances; if any interest is
received on such balances, it will not usually run higher
than 2 per cent. On the other hand, every corporation
naturally desires to stand well with banks and will carry
large enough balances to make its deposits worth having.
Otherwise, the corporation in times of difficulty may
turn to banks in vain for temporary assistance.

The amount of accounts receivable cannot be de-
termined by the financial management of a corporation,
but depends on the volume of sales, on the custom of the
trade as regards payment and on the efficiency of the
credit department in granting credits and in making

The amount of finished products and raw materials
on hand is directly determined, of course, bj' the operat-
ing department of each company. Nevertheless, the
executive heads of the company should and usually do


exercise some discretion in this regard, particularly with
a view to reducing the amount of working capital thus
invested to a minimum. A great many manufacturing
corporations, on account of improper purchasing and
accounting methods, are wasteful in this regard. Care-
ful perpetual inventories of goods in stock will often
make it possible to buy and sell more closely without
interfering in the least with the operating efficiency of
the business. Although this is a topic which belongs
rather to organization and accounting than to finance,
its importance to a corporation's financial management
should not be overlooked.

160. The practice of large corporations. — The fol-
lowing compilation made by the Wall Street Journal
is of particular interest in that it shows the practice with
regard to working capital of the largest and best-man-
aged corporations.

A study of reports of the leading industrial companies shows
that the United States Steel Corporation takes the lead in work-
ing capital, with the Standard Oil Co. second, the International
Harvester Co. third and the General Electric Co. fourth.

Including sinking and reserve fund assets invested in securi-
ties, amounting to $32,442,400, the working capital of the U.
S. Steel Corporation is $261,789,885.

The International Harvester Co., aside from the Standard
Oil Co., probably has a larger working capital to gross business
than any other corporation of consequence. Its working capi-
tal as of December 31, 1907, aggregated $77,087,811, while its
gross business amounted to only $78,206,890.

The General Electric Co. also shows up well from the stand-
point of working capital, reporting $61,235,724 on January
31 last, compared with its gross business of $70,977,168.

The following table gives the working capital of several
of the prominent industrial companies, together \5ith gross busi-
ness and capitahzation for their respective fiscal years :


Company Gross Working Capital

Year Ended Business Capital Stock

United States Steel

Dec. 31, 1907 $757,014,767*$261,789,885 868,583,600
Internat. Harvester

Dec. 31, 1907 78,206,890 77,087,811 120,000,000
General Electric

Jan. 31, 1908 70,977,168 61,235,724 65,167,400

Westh. Elec. Mfg.

Mch. 31, 1907 33,026,240 19,061,807 24,969,000

Lack. Steel

Dec. 31, 1907 33,011,410 13,881,340 34,721,400

Republic I. & Steel

June 30, 1907 31,229,423 6,720,000 47,607,900

Beth. Steel

Dec. 31, 1907 15,000,000 7,434,573 29,770,000

Am. Steel Foundries

July 31, 1907 19,463,521 4,834,843 17,184,000

Midvale Steel

Oct. 31, 1907 . 1,804,929 750,000


June 30, 1907 12,522,074 35,790,000

Cambria Steel Co.

Dec. 31, 1907 . . . 14,597,865 45,000,000

Total $730,970,851 $1,389,570,450

The above figures show that the twelve companies in question
are well fortified with working capital. The aggregate working
capital stands at $730,970,851 as compared with total stock cap-
italization of $1,389,570,450.

The figures given above indicate that the companies in ques-
tion are in a strong position to weather the depression through
which they are now passing.

* Includes sinking and reserve fund assets amounting to $32,442,401.


To invest working capital to any considerable amount
in the securities of other corporations is not a very com-
mon or commendable practice. It is justifiable only in
those companies that have great fluctuations in demands
for cash and that carmot secure fair interest on bank
balances. The buying and selling of securities is no
part of the business of any corporations except the few
which are distinctly organized for that purpose. Prof-
its that are derived from this source are justly regarded
as speculative and highly uncertain.

161. Factors that affect working capital. — Consider-
ing the situation as a whole the proportion of working
to fixed capital in any business may be said to depend
upon five factors, as follows:

(1) Volume of business.

(2) The regularity of supply of whatever raw ma-
terials are used and the savings which may be effected
by buying raw materials in large quantities. If it is
necessary for the corporation to pick up large batches
of raw materials at irregular periods in order to get ad-
vantageous terms, of course the working capital must
be correspondingly increased, for two reasons : first, be-
cause larger amounts of raw materials must be carried
in stock than would otherwise be necessary; second, be-
cause larger bank balances must be maintained in order
to meet these irregular demands.

(3) Regularity of the demand for the product of the
corporation. The same considerations apply here as
were named in connection with the preceding factor.

(4) Customs of payment in the business. Some
manufacturing corporations normally buy on 90 days'
time and sell on 30 days* time. This arrangement makes
it possible to meet the accounts payable out of accounts


receivable and lessens the necessary amount of working

(5) The length of time required to turn out the
finished product. It takes three or four years normally
to build a big steam vessel. During that period the
ship-building corporation will necessarily pay out large
sums for lumber and materials and a big working capi-
tal, therefore, will be necessary. The same remark ap-
plies to all concerns in which the period of manufacture
is lengthy.

There is one great industry of the United States
which can usually get along with a very small proportion
of working capital, namely, railroad operation. The
prime reason is that the railroads are manufacturing a
commodity, that is, transportation, which is continually
in demand and which is paid for ordinarily as soon as it
is produced. There are no outlays to speak of for cur-
rent raw materials; the only raw materials that railroads
use are for fixed assets and may be regarded as part of
the cost of securing fixed capital.

162. The working capital of the Pennsylvania Rail-
road. — Even among railroads there may be exceptional
circumstances which make necessary large working
capitals. The Pennsylvania Railroad, for example, in
the early part of 1909 was completing its immense ter-
minal improvements in and near New York City. In a
sense it was engaged in the contracting business on a
great scale, for it was building tracks, tunnels and sta-
tions. Therefore, it heeded temporarily as much work-
ing capital as a manufacturing corporation should have.

Making a strict classification of current assets and
liabilities, the Pennsylvania Railroad's cash position at
the end of 1908 compares with its position twelve months
before as follows:



1908 1907 Changes

Cash $56,035,898 $37,385,673 Inc. $18,640,235

Bills & accts. recv 14,394.,080 18,069,840 Dec. 3,775,860

Cash assets $70,319,978 $55,455,613 Inc. $14,864,365


Payrolls & vouch $14,337,369 $20,236,164 Dec. $ 5,998,795

Int. accrued, etc 3,231,248 3,875,982 Inc. 355,266

Miscellaneous 4,211,496 3,966,996 Inc. 244,500

Current liabilities $21,670,113 $27,069,143 Dec. $ 5,399,039

Excess cur. assets 48,649,865 38,386,471 Inc. 30,163,394

This makes the company's net free capital, subject to
the company's need of money to carry on its everyday
business of transportation, more than $48,000,000 and
$20,000,000 in excess of what it had been the year before.
The other assets, not to be classed as quick items but more
or less subject to liquidation in time, and deferred and
contingent liabilities, compare as follows:


1908 1907 Changes

Due on N. & W. & C. &

O. stocks $15,493,685 $15,492,685

Loans for cons., &c 12,403,834 18,413,493 Dec. $ 6,008,659

Due from controlled com-
panies 3,159,784 463,318 Inc. 2,697,566

Materials on hand 10,449,483 15,939,935 Dec. 5,480,443

Sink, fund assets ' 8,148,308 7,772,637 Inc. 375,581

Total $49,653,994 $58,069,948 Dec. $ 8,415,954


Car trusts chgd out .... $ 2,043,803 $ 1,424,871 Inc. $ 618,929

Taxes chgd out 2,731,109 3,023,197 Dec. 292,088

Due Penna. Co 3,390,897 Dec. 2,290,897

Extr. exp. fund 3,500,000 Dec. 2,500,000

Sinking fund liab 10,339,057 9,815,956 Inc. 533,101

Total $15,113,966 $19,054,921 Dec. $ 3,940,955

Excess def. & con. assets $34,540,038 $39,015,037 Dec. $ 4,474,999


163. General conclusions as to working capital. —
Many other industries, particularly those manufacturing
staple articles of trade, require a comparatively small
proportion of working capital. On the other hand, there
are lines of business, such, for instance, as publishing,
in which practically no fixed capital (office furniture,
perhaps, excepted) is needed. This is true more or less
of all trading corporations.

As was intimated at the beginning of this chapter, the
principles herein laid down are of a very broad and
general nature and can be successfully applied only by
keen intelhgence. Perhaps the chief practical con-
clusion is that the most careful thought must be given
to securing a proper proportion of working capital. No
matter how valuable the fixed assets of a corporation
may be, if it does not have all the funds necessary to
transact current business and to meet current obligations,
it will inevitably prove a failure. Right here is where
most of the mistakes and failures of the early stages of
corporate management occur. Managers trust that the
current sales will take care of current expenses; when
the inevitable hitch occurs they have no other resourcfis
to use and the corporation suddenly plunges into the
quicksands of financial trouble and discredit. This
problem of providing sufficient working capital will
crop out again when we come to consider the causes of
corporate insolvency.



164. Determination of income. — The ordinary form
of" income statement of a corporation is somewhat as
follows :





Gross earnings from operation or manufacture.

Deduct operating or manufacturing ex-
Net earnings from operation or manufacture.

Add income from other sources.
Total income.

Deduct taxes.
Balance applicable to fixed charges.

Deduct interest.

Deduct rentals.

Deduct sinking fund and other charges.
Balance applicable to dividends and surplus.

Deduct dividends.
Surplus from the year's operations.

It goes without saying that each corporation has its
own methods of stating accounts and that there are
many variations from this standard form. The essen-
tial items, however, are those stated above. It would
be well for the reader to study with some care the income
accounts of large corporations which are made public
from time to time and which are printed in the financial
columns of all metropolitan newspapers. If any of the
items given above are not altogether clear, the reader



should turn to the volume on Theory and Practice of
Accounting and go over the explanation there given
of the income statement.

The relations between accounting and finance are so
close that a fair understanding of the basic principles
of accounting is necessary in order to deal intelUgently
with the problems of financial management. In what
is said below in reference to each of the items in the
income account it will be assumed that the reader is
familiar with accounting terms and with the elements
of accounting practice.

165. Honesty in stating gross earnings. — Perhaps
the only comment needful on the first item "gross
earnings" is that it should be honestly stated. This
remark is trite enough, and yet not uncalled for. A
great many corporation managers are in the habit of
including in their gross earnings sales that have been
made to parties of doubtful credit which are represented
merely by accounts receivable that are probably bad.
In the case of holding companies it is not so uncommon
as it should be to include in the gross earnings sales
made from one company to another in the combination.
Of course this is simply a juggling with figures. A
still more flagrant instance of dishonesty was disclosed
by Mr, Stephen Little, an accountant of wide reputa-
tion, who in 1894 was called upon to investigate the
condition of the insolvent Atchison, Topeka and Santa
Fe Railroad Company. Mr. Little found that the
railroad had paid out millions of dollars in rebates to
shippers which had not been deducted from its state-
ment of gross earnings.

166. What are operating expenses? — Operating ex-
penses are also often grossly misstated, although in this
instance the fault is apt to be due, not so much to the


dishonesty of the corporation managers, as to their
ignorancie of correct accounting principles. The oper-
ating expenses ought always to include not only the
actual expenditures for raw materials, labor and current
repairs, but also a liberal allowance for anticipated re-
pairs and renewals and for depreciation.

Repairs in the early years of a corporation's activities
are seldom as great a burden as in later years. Ac-
countants figure that most manufacturing machines
will show a rising percentage of necessary repairs each
year for the first five to ten years of its existence and
after that a fairly steady ratio will be maintained. Now
it is evident that unless some allowance is made during
the first few years for the rise in this item during the fol-
lowing years, a misleading statement of operating ex-
penses will be presented.

Corporations differ greatly in their handling of
charges for renewals of machinery and equipment.
Many of them figure that the new machines they buy
are additions to their capital and therefore should not
be charged against the income account at all. If the
new machine, however, replaces to any extent an old
machine, this reasoning is obviously incorrect. Only
the difference between the value of the old and the value
of the new machine could properly be charged to capital
account. Conservative corporations in this country,
railroads particularly, are in the habit of charging the
whole cost of their new equipment, as a rule, as a part
of operating expenses. The English railroad practice,
on the other hand, is to charge the whole expense to
capital and to raise new capital funds to meet it. We
shall have occasion to consider this point further in con-
nection with "betterment expenses."

167. Necessity for depreciation reserves. — The sub-


ject of depreciation is too large and important to
receive full consideration in this place ; a more extended
treatment will be found in the volumes on accounting.
As the desirability of allowing properly for deprecia-
tion ought to be indelibly impressed on the mind of
every person interested in corporation management,
however, some brief remarks on the subject, even at the

Online LibraryWilliam H. (William Henry) LoughCorporation finance; an exposition of the principles and methods governing the promotion, organization and management of modern corporations → online text (page 22 of 34)