TRADE CREDIT AND BANK LOANS 1. Corporate loans and liabilities.—Corporations can secure capital only by gift, the sale of capital stock, or borrowing. The borrowing may take any one or more of numerous forms. The chief means by which corporations can borrow are: Trade credit Short-term bank loans or discounts notes Bonds This classification is a broad one used to analyze the motives underlying the various types of corporate obligations. Any form of loan constitutes a liability and should appear as such upon the company's books. On the other hand, the capital stock of a corporation does not represent a liability, for the reason that it is not a debt. The stock, nevertheless, to the extent actually paid in, stands on the liability side of the balance sheet to represent the investment of the own ers in the corporation. This is termed "stock lia bility." By accountants, it is called an "account ability." When, for the purpose of obtaining cash, a cor poration discounts at the bank, notes which it has received from customers in settlement for goods or services sold, or, when the company assigns its ac counts receivable, the transaction is more in the na ture of a sale of assets than in the nature of a loan. It is customary, in such cases, however, for the cor poration rediscounting or selling its accounts or bills to guarantee or indorse them, thus assuming an in direct or contingent liability. Such contingent lia bility should be noted on the company's statement, but is not found on the balance sheet. This fact is often overlooked in compiling or analyzing corporate statements for credit purposes. A contingent liability often develops into a real debt, tho it may not appear in the balance sheet.
2. Why corporations borrow.—Why do corpora tions borrow? Why create a debt, which must be re paid with interest, when the sale of additional stock would bring funds permanently into the business without a fixed liability for interest? The reasons are: 1. That capital stock in many corporations does not attract investors and cannot be advantageously sold 2. That general market conditions often preclude the sale of stock ( as during panic or depression) 3. That new capital is often required for only tem
porary or seasonal purposes which do not justify se curing additional permanent capital 4. That present stockholders profit more by bor rdwing at a low rate and investing at a higher yield than by increasing the stock capitalization.
Oftentimes the company's record of earnings is so poor, or the risks of the business so great, that com mon, and even preferred stock, cannot be sold to advantage ; and yet the same company, by pledging assets on hand, may be able to borrow on fairly good terms. If, for instance, a market could not be found for seven per cent preferred stock above 80 per cent of par, but the corporation could pledge assets which would enable it to borrow on bonds at the rate of six per cent, it is plain that financial advantage to the present stockholders would accrue from borrowing, in so far as it could be done safely.
This thought lies at the heart of the financial plan in determining the character of the capitalization. To illustrate, let us take a company having outstanding one thousand shares of common stock, total par value $100,000, and one thousand shares of seven per cent preferred stock, par value $100,000. Presuming that this company is earning ten per cent, the preferred stock will be receiving regular seven per cent divi dends, leaving $13,000 annually available for distri bution to common stockholders, or 13 per cent divi dends.
If, now, this company desires to extend its busi ness by the addition of $50,000 new capital, the hold ers of common stock, who control the company, will have three methods to consider: the sale of com mon stock; the sale of additional preferred stock; the sale of six per cent mortgage bonds. Let it be assumed that any or all of these may be sold at par and that the earnings of the company are sufficiently stable to insure the regular payment of interest upon the bonds and dividends upon the preferred stock. Granting that the new capital earns the same profit for the company as the old, the net earnings available for interest and dividends will now be $25,000 each year instead of $20,000.