Stated in the simplest possible manner, a corporation disburses its gross income in the form of : Operating expenses (where, for our present purposes, we will include taxes as well as maintenance, etc.).
Interest.
Dividends.
We by no means take this as a model of accounting practice, but simply to keep the elements entering into trading on the equity down to their simplest terms.
Safety or danger in this manner of conduct ing business depends on the interplaying re lations of gross income, operating expenses, and interest charges, and the range of fluctua tion of " gross " and " operating." Net income offers the first and immedi ately significant figure. Its amount and fluc tuation, however, depend directly on the amount and range of fluctuation of gross in come in relation to the amount and range of fluctuation of the percentage of the gross in come used in operating expenses. We may call this the "business risk," because it de pends on the nature of the business and the ability of the management. Though no finan cial plan can affect either, the business risk should be a controlling influence in the ar rangement of any scheme of financing an enterprise.
Surplus, which is the fund out of which dividends may be paid, gives the next and secondarily significant figure, and the one directly affecting the shareholder. It de pends on the fluctuation of net earnings in relation to the amount that interest charges consume. We may call this the "financial risk" as distinct from the business risk. The thinner the equity or margin the shareholder works on, the greater the risk that the share holder runs and that he places on the bond holder.
To carry on the illustration already used, suppose the proprietor of the business de cided to extend his borrowing to the utmost limit of his credit and found that he could raise $80,000 additional capital. The lend ers are taking a greater risk and insist on a greater income, say 10 per cent. This is a regular principle. As the equity gets thinner, interest charges increase more rapidly than the increase in the capital advanced. The more money the proprietor borrows, the more interest he has to pay on each borrowed dollar.
Now the annual statement will show: Personal capital invested . . . $20,000Borrowed capital invested . . . 80,000 Total capital invested . . $100,000 Percentage earned on capital . 15 per cent Total return on capital . . . $15,000
Ten per cent on borrowed capital . 8,000 Return on personal capital . . . $7,000—or 35 per cent on the personal capital in vested. When the proprietor had borrowed only $20,000, he made 22 per cent on his own capital. By larger borrowing he has made a clear gain of 13 per cent more on his personal funds.
Heretofore the proprietor, however, could suffer a decline in the prosperity of his busi ness that reduced earnings from a basis of 15 per cent to a basis of 5 per cent on the total capital invested in the business and still make something on his personal capital. Suppose now that the earnings on invested capital fall, not to 5 per cent, but to 8 per cent. Then: — Total return on capital . . . $8,000 10 per cent on borrowed capital . 8,000 Return on personal capital . . . $0,000 If the return on invested capital should de cline to 5 per cent, the proprietor would face an annual deficit of $3000, and very quickly would have to go into bankruptcy.
Business risk, as we have seen, depends on: the amount of gross; its range of fluctuation; the percentage of gross used in operating expenses; the range of fluctuation of this percentage. In their very nature businesses vary greatly in these respects.
We shall take several corporations, en gaged in different kinds of business, to illus trate these variations caused by the nature of the enterprise. Let us first consider fluc tuations in gross earnings. The five-year period chosen for illustration includes the year 1908 so as to get the effect of the change from a time of business activity to a time of business depression. A plus mark indicates an increase and a minus mark a decrease in gross earnings over those for the preceding year.
Without looking at the balance-sheets, any one would come to the general conclusions about probable variations in the range of fluctuation in gross earnings of the several classes of business used for illustration which the figures given actually show. Industrial corporations feel a business depression most strongly. People do not embark on new enter prises. This fact immediately causes the con sumption of materials to fall off. Established businesses economize as closely as possible and cause a still further decline in the demand for materials. Such conditions show with spe cial acuteness in the earnings of a company like the United States Steel Corporation.