If, then, a company manufacturing steel, and a company manufacturing woolens, un dergo about the same degree of fluctuation in gross income, apparently the company manufacturing woolens at an average oper ating ratio of 92 per cent cannot safely trade on as thin an equity as a company manufac turing steel at an average operating ratio of 77 per cent. Neither can safely trade on as thin an equity as a railroad with a much nar rower range of fluctuation of gross, and an operating ratio averaging 63 per cent.
Going on with the comparison of operating ratios, take in the same order as before the Thus it appears, if these may be taken as typical operating ratios, that an electric light ing company or a street railway company can safely trade on a thinner equity than a rail road, not because their operating ratios are less, but because they are not so subject to declines in gross earnings as a railroad.
To complete the comparisons, consider the operating ratios of a hydraulic electrical power company.
Here we have an operating ratio materially lower than those of the railway, traction, and lighting companies, — hardly one fourth as great, and scarcely more than a fifth of those of the industrials cited. This comes about from the fact that the labor cost is practically nothing in comparison with the capital in vested, and from the substantial nature of the works, the maintenance is low. A hydraulic electrical plant represents a large amount of capital used in construction of an exception ally solid kind. It runs almost automatically.
The promoters or managers of a company operating one would be safe in trading on a thinner equity than would be proper in almost any other common form of enter prise.
Having discussed the business risk, the interplay of the fluctuations of gross income and operating expense in determining net, we are now ready to consider what we have termed the financial risk. This, as we have stated, depends on the relation of interest charges to net earnings. Here, instead of hav ing two variables, we have only one. Interest charges are a fixed quantity. We have seen that though operating expenses do not de cline proportionately with gross, their act ual amount does, nevertheless, fall. Interest, however, does not decline at all, but stays absolutely rigid. We have this situation, then, — with a declining gross an even more rapidly declining net, and a surplus declining more rapidly still towards vanishing point.
Suppose we have a corporation earning, gross, $1,000,000, operating ratio, 75 per cent, with gross liable during a period of depression to fall 35 per cent from normal, and its oper ating ratio to increase to 80 per cent. Let the
corporation be carrying an interest charge of $125,000, or 5 per cent on $2,500,000 bonds. The result is: That is, during a period of depression with a decline in gross of 35 per cent, and an increase of 5 per cent in the operating ratio, net has declined 48 per cent, and surplus has declined 96 per cent.
Recalling the earlier part of this discussion, we remember that gross of the United States Steel Company fell off 37 per cent in the de pression following the Panic of 1907, with a 3 per cent increase in the operating ratio, and gross of the American Woolen Company at the same time suffered a decline of over 45 per cent, with an increase in the operating ratio of 5 per cent. Obviously the sharehold ers of an industrial enterprise subject to such fluctuations as this cannot safely authorize the creation of an indebtedness large enough to reduce their equity to a point where in prosperous times the corporation will have to disburse half of net earnings in interest charges. If they do, they will be running a pretty good chance that during the next de pression, not they, but a reluctant body of bondholders, not at all pleased at the author ity thrust upon them, will be in control.
Suppose, in a corporation, the gross earn ings of which are now, in normal times, $1,000,000, liable to suffer a decline of 35 per cent in gross during a period of depression in the business, that for every 7 per cent de cline in gross the operating ratio will advance 1 per cent. The operating ratio is now 75 per cent. This approaches the case of the Steel Corporation.
The situation shown graphically (see dia gram opposite) may become a little clearer.
The curve of operating will fall as the curve of gross falls, but not at the same rate. That part of the diagram between the curve of operating and the curve of gross represents the amount of net. Interest is a constant amount. The curve of operating, plus inter est, indicating that part of earnings which, subtracted from gross, gives the surplus, re sults from simply adding the constant, inter est, to the curve of operating, and gives a line exactly parallel to the curve of operating. Since the curve of operating does not parallel the curve of gross, but approaches it, the graph shows at a glance the effect on surplus of add ing the constant, interest, to the operating.