A second common practice is the attempt to cover depreciation entirely by current expenditures for re pairs and replacements. A concern which is so large that the replacement of the largest machine or build ing is a mere incident of operation may hold its physi cal plant at par by liberal expenditures for replace ment and improvements. But a small concern, for which the replacement of a large unit of capital goods, such as a hydraulic press or an elevator or a building, would be an overload if charged off in a single year, may well supplement a depreciation reserve with a special capital fund built up thru contributions made from time to time. • To neutralize decrepitude completely and to care for calculable obsolescence and inadequacy out of revenues before calculating net income, is common honesty. To make liberal appropriations out of profits for betterments, to anticipate possible obsoles cence and inadequacy due to those sudden and un foreseen changes of production, which in this day of scientific progress so suddenly scrap equipment and antiquate processes, is superior prudence.
A lavish appropriation for betterments and exten sions, when it is handled as a simple offset to deprecia tion, is the process of building up a secret reserve. This is a process which is sometimes compulsory un der the terms of exacting mortgages and trust deeds, but which is occasionally voluntary to keep rates from being lowered by rate-regulating bodies, to get the better of holders of income bonds, or to reduce the price of shares with a view to shaking out weak hold ers.
As an illustration of sound practice, it may be men tioned that the General Electric Company charges off annually 10 per cent of the actual value of the phy sical plant, the International Harvester Company 10 per cent, and the United States Steel Corporation 7 per cent.
9. Total net income.—When total net income has been discovered by adding together the net income from operations and "other income," the stockholder may well pause to compare this figure (or an average of it for five years past) with the capitalization. How does the actual capitalization compare with the cap italized net income? The answer depends upon the rate of capitalization used. This can be determined only by averaging the yield of securities of the type involved as issued by similar industries. Mr. John Moody has stated that industrial shares usually sell for from two and one-half to eleven times their por tion of the annual net earnings.
10. Fixed charges include inter est, taxes and reserve-fund requirements. It is im portant to note that they should be kept well below the lowest point to which net income is likely to shrink in years of depression. In this connection it should be observed, also, that the larger the percentage of revenue absorbed by operating expenses, the more seri ously will a given shrinkage in revenues affect net in come, for the reason that expenses of operation do not decrease in the same ratio with decrease of revenues.
For example, the Mohawk Gas Company, serving Schenectady, New York, suffered a decline of gross earnings in 1908 and 1909. Operating expenses could not be reduced correspondingly, so net earnings suffered a greater relative decline than did gross earn ings. The situation can be seen clearly by reducing each column of figures to percentages, the respective figures of 1906 being taken as 100 per cent in each in stance. In this case the gross earnings fell off 11.01 per cent, and since operating expenses could be re duced only 9 per cent, the net earnings fell off 14.63 per cent.
11. Sinking funds.—Sinking funds are rare in railway finance, familiar in connection with industrial bonds, common in the public utility field, and usual in coal mining and lumbering and in municipal fi nance. Their purpose is, for one thing, to employ a simple easily enforceable provision for improv ing the 'ratio between debt and security, instead of provisions for the maintenance of property, which are more difficult to enforce and require a supervision that is regarded by the management as meddling. Creditors who make a long time loan naturally seek to guard against the possible development of unfavor able business conditions. A small provision will work wonders against a distant danger. One-fourth of 1 per cent on a .5 per cent fifty-year bond callable at par will retire 52 per cent at maturity, while one-half of 1 per cent will retire all.
In prosperous and growing business there is an ob jection that sinking funds lock up funds in pure in vestment at low yields which might secure the debtors' claims better if spent to enlarge the earning power of the business. In such cases the object desired may be attained by stipulating for an improvement fund. It is rare outside of businesses with wasting assets that a sinking fund is intended to bring about complete amortization of indebtedness. As a rule, sinking funds are administered without set requirements.
Requirements may, for instance, provide for the set ting aside of a given sum each year, or so much per ton of coal mined or per 1,000 board feet of timber cut. There may be provisions, too, for the applica tion of a given percentage of gross or net income, or of the surplus of net income after interest and an agreed rate of dividends has been subtracted. A given percentage of outstanding debt, or a given per centage of the original issue of bonds, may be retired.