SPECIAL NATURE OF THE INCOME OF A HOLDING COMPANY The corporation may be entirely a holding company and not conduct any operations at all, or it may be partly a holding company and partly an operating company. Hereto fore we have generally been viewing the earn ings of a corporation as the result of directly conducting a business. For the most part, when discussing earnings, we have assumed simply that the earnings were those of an operating company. We can come to a true understanding of the income account and of the relationship of earnings to the various security issues of the plan of capitalization only by tracing them clear through from their origin as "income from operations." Each corporation intervening between "income from operations" and any part of income available for interest or for dividends creates a difficulty of analysis.
Securities of holding companies are some times presented to the capitalist with the statement that earnings available for interest amount to so many times the amount required for that purpose, or that the earnings available for dividends amount to such a per cent on the stock. The presentation does not go back of the income of the holding company and may mislead those who are not familiar with the special nature of the earnings of a holding company and do not reflect on the situations that may arise through the intervention of an operating company. Another way in which those who are raising funds through the sale of securities of a holding company may mis lead the unwary is by failing to protect the investor from the possibility of having new claims superior to his own created against earnings and assets.
Let us take a concrete situation to show the difference between the earnings of a holding company and those of an operating company. Assume a holding company — D — capital ized and earning as follows: — Holding Company D Capitalization Bonds, 5 per cent $1,000,000 Stock 1,000,000 Net earnings 100,000 Obviously the statement can be made of the bonds of this corporation that the earnings available for interest are twice the amount required for that purpose. If the corporation were an operating company deriving its in come from rendering a public service, such a showing would indicate a minimum of risk in the bonds as an investment. Let us now
make the further assumption that the holding company owns all the capital stock of three subsidiaries, Corporations A, B, and C, and that it has no other assets. Since the holding company owns all the stock of the subsidi aries, the number of shares of that stock does not matter; the holding company is entitled to all the dividends which the subsidiaries may declare.' So the only element of real concern to us at this point, in connection with the capitalization of the subsidiaries, is the amount of bonds they have.
Let us assume that the subsidiaries have bonds outstanding as follows: — Bonds of subsidiaries Corporation A, 5 per cent bonds ...... $1,000,000 Corporation B, 5 per cent bonds...... 1,000,000 Corporation C, 5 per cent bonds ...... 1,000,000 For our purpose here we do not need to set out the entire income account of each of these corporations. So, without presenting this, we will show simply the totals of the several items of the income account for all three, that is, a consolidated income account. Let us assume, then, that the consolidated income account of these three subsidiaries makes this showing: Consolidated income account of subsidiaries Gross earnings $500,000 Operating expense 250,000 Net earnings 250,000 Interest . 150,000 Surplus available for dividends... 100,000 To simplify the problem we can further assume that the management of the enter prise carried out by the holding company and these three subsidiaries has not adopted a policy of building up a surplus. Accordingly, let us have all this surplus available for divi dends declared as dividends out of the treasury of the subsidiaries. The holding company, then, receives this $100,000 into its treasury. We can neglect the expenses of the holding company, which, since it does not conduct any operations, would be merely nominal, a matter of keeping a not very extensive set of books, and assume that this entire $100,000 becomes net earnings of the holding company. Looking back to the statement of net earnings of the holding company one will see that we have assumed this as the situation.