It is sometimes said that dividends are paid out of surplus. They are paid out of cash on hand, or in bank, or from bank funds obtained by pledging prop erty. They are charged to surplus, which is quite an other matter. Whether there is a true surplus that will warrant dividends depends not upon the item "surplus" itself, but upon the accuracy of the entire balance sheet which permits such an item to emerge on the liabilities side.
7. Income second division of a cor poration report consists of the income account. It would be of great value to investors if such accounts began with revenues from operations, and deducted operating expenses and depreciation separately to ar rive at net income from operations or earnings, add ing "other income" after this to make up total net income. This, in turn, should be diminished by fixed charges, separately itemizing interest, tax payments to arrive at the surplus available for dividends. Sur plus should, then, be diminished by the separate sub traction of dividends and special appropriations, leav ing unappropriated surplus.
Such an arrangement of items is far from being the rule. The income accounts of American cor poration reports show great variety in their degree of completeness and incompleteness, in the order in which the items are subtracted, and in the titles ap plied to the various intermediate remainders. Some statements begin with gross sales or revenue from operations, while others start with profits, leaving the readers to imagine how they were determined. Some leave depreciation, and even general expense, to be taken out of net income, while others more sensibly take these items out of gross revenues from opera tions. Some deduct operating expenses as a single item, while others are not ashamed to show sepa rately what they have allowed for depreciation and maintenance.
It is desirable that income from operations should be distinguished from income derived from other sources, such as investments, in order that the effi ciency of the management of the operative depart ments may be judged. When income from opera tions and operative expenses are given, it is possible to calculate the operative ratio, or the percentage of income absorbed by expenses. This figure is com monly used in the analysis of railway reports. It may sometimes be made useful in the study of indus trial reports.
8. is a most impor tant part of operating expenses, and a part upon which the investor needs to keep the closest watch. It is composed, first, of decrepitude, or the slow wearing down of physical properties, due to usage and the ravages of the elements ; second, of obsoles cence, or reduced usefulness due to change of style or improvement in productive processes; and third, of inadequacy, or diminished value due to the increased scale of operations and the inability of a given unit of equipment longer to coordinate effectively with other units.
The average depreciation of brick buildings has been estimated at per cent annually, of frame buildings at 2 per cent, of furniture and fixtures at 5 per cent, of tools and machinery at 6 per cent (but at 10 per cent per annum for the first two years) , and of stock at 20 per cent. The ability of the in vestor to apply these elementary rates depends, of course, upon the analysis of physical property fur nished in the corporation report. Mr. John Moody has estimated the collective rates of depreciation of the physical property of gas companies at 3 per cent, of railroads at 5 per cent, of cotton mills at 5.5 per cent, of street railways at 5.6 per cent, of manufactur ing companies in general at 6 per cent, of steel com panies at 7 per cent, of coal companies at 7.5 per cent, of equipment companies at 8 per cent, and of copper companies at 9 per cent.
Lack of definite information is next door to a con fession of defective practice. Many American indus trial corporations make no allowance for depreciation, thinking to offset it with the appreciation of such as sets as real estate and good-will. In the meantime they use all their funds to extend operations to the extreme limit in the hone of achieving a more im portant economy froni operation on a large scale. There are three objections to this policy. One is that appreciation of real estate does not give a cur rent asset available to pay for new buildings and equipment. Then, while appreciation is uncertain and temporary, depreciation is as inevitable as death and taxes. And, finally, an over-extended condition lays the stockholders' equity liable to sudden extinc tion by an adverse swing of the constantly fluctuating American market.