As the outline of the income account has indicated, the corporation may not distribute in the form of dividends all the profits which are stated to be "available for dividends." All the phrase means is that of the earnings stated for the period of the report the corpora tion has the legal right to distribute to share holders that amount as profits of the business. Legal right and financial expediency ordina rily in this respect come to two very different results. It is generally desirable to adopt such dividend policy as to avoid, so far as possible, the necessity for reducing dividends during ordinary periods of depression. From the viewpoint of the corporation itself the investor occupies a much more important place in the financial scheme than the specu lator. The investor seeks steadiness of in come and commits his capital to such invest ments as seem likely to give it. He does not want merely an average of five per cent or six per cent over a period of years; he does want the actual five or six per cent every year. So the management of a corporation would ordinarily find it desirable to pitch its divi dend policy at such a point that they feel con fident they can maintain it.
The directors will, therefore, not declare as dividends the entire amount legally available for that purpose, but will set aside part of it to surplus account.
The amount so set aside does not, of course, ordinarily, except for accounting purposes, constitute a distinct fund. The directors sim ply invest those earnings back in the plant in extending or bettering it. Though ac counted for in a separate account as surplus, they really make essentially an addition to the capital account. By reason of the exten sions or betterments the corporation should increase its earnings. The surplus ought to be sufficient to enable the corporation in its dullest years to earn the amount required for its regular dividend rate. When the earn ings, as a result of this policy of accumula tion of surplus, reach a point where they can be relied upon to do more than this, then the directors can increase the dividend rate. If the directors are not certain that earnings have reached a point to justify an increase in the regular dividend and the sur plus cannot be invested back in the plant to the best advantage, they may increase the distribution, but expressly announce the ad dition as a "special dividend" by way of giving warning that it is not to be relied upon as a regular disbursement of income.
Just how much of earnings should be set aside as surplus for the sake of establishing the continuity of dividends presents a ques tion requiring much wisdom in judgment. The general subject of corporation finance needs the results of much study on this prob lem. Only a few kinds of business yet afford even the materials for this study. Due to
the requirements of the Interstate Commerce Commission the railroads have made public an abundance of material for that form of business. Various state public service com missions are bringing out enough material for the several kinds of public utilities. But for the various kinds of manufacturing business, not only is the material not available, but the problem is more difficult. In the public utilities field, however, this study is especially needed as part of the foundation for rate making. Public service commissions purport to fix rates at a point that will allow a fair return on the capital. Earnings must be large enough to allow interest and dividend rates sufficient to attract new capital to the enter prise to provide the extensions and better ments demanded by a community growing either in size or in its demands for quality of service. As already stated, investors demand, or prefer, a steady income, and will advance funds on more advantageous terms on the assurance of a steady income than on the fact of an equivalent average income. So, part of the problem of rate determination is what rate of steady income reasonably assured will prove sufficiently attractive to procure neces sary new capital for the enterprise, and what amount of surplus set aside under circum stances of favorable earnings will give that reasonable assurance of continuity. Rates must be established at a point which will enable the payment of the required steady in come and provide for a surplus fund which will in a degree guarantee the continuity of this income. That word " guarantee " indi cates the essential nature of a surplus fund; it might with sufficient propriety be described as a "guaranty fund." We have said that the directors invest the surplus back in the plant. In most cases they do. It may happen, however, that they can not advantageously make this investment, or that they have special reasons for not doing so. Under such circumstances they may invest in special ways some or all of the earnings which form the "surplus after dividends," just as a sinking fund is invested. The cor poration then has a distinct surplus fund which affords earnings from sources outside the regular business it carries on, and shows its guaranty nature more distinctly than an investment back in the plant. Though cre ated primarily for the purpose of assuring continuity of dividends, the surplus fund also goes to the building of a larger equity back of the bonds. The stockholder wants as much of the earnings available for dividends dis tributed to him as possible without interrupt ing the continuity of dividends, and always welcomes any increase in the disbursement. The bondholder always likes to see earnings go back into the plant.