Distribution if bonds are issued: It is plain that the common stockholders profit by issuing bonds rather than preferred stock, or pre ferred stock rather than common, because the new capital earns more than the interest or preferred divi dend rate. This principle always holds true when earnings upon new capital are higher than the inter est paid for loans, and are regular enough to insure the continuance of interest payments in good times and bad. By assuming the marginal risks of the en terprise, the common stockholder is able to retain, either in the increased value of his stock or in the dec laration of dividends, the entire earnings of the busi ness above the fixed interest paid upon loans and the fixed dividends upon preferred stock.
3. Use of trade credit.—Practically all business concerns borrow in some form or other. Many con cerns have no bonds outstanding and others borrow nothing from the banks or from the public upon notes, but practically all utilize trade credit as a source of capital.
Trade credit consists in the delivery of goods or services to the customer upon the express or implied promise of future payment. It is usually in the form of the sale of merchandise on time, the credit appear ing either as an open ledger charge on the books of the seller, verified by the shipping documents, or in the form of a promissory note or trade acceptance, executed by the customer in favor of the seller. In either case, the obligation falls due upon a specified date, or within a certain number of days or months from the date of shipment. The obligation may bear interest at the current rate. If the seller draws on the buyer for the amount of the invoice, and the draft is accepted by the purchaser, it becomes a trade ac ceptance. The transaction ceases to be an account re ceivable on the seller's books. It may be carried as a "note receivable" along with promissory notes, or which is better practice, be carried in a separate ac count.
The net result of such trade credit is always to in crease temporarily the capital of the customer at the expense of the seller. The customer, to this extent, becomes a borrower; the seller, a lender. Most firms in business make a continuous practice of purchasing largely on time, employing to that extent the capital of others in their business.
4. Open account as a selling inducement.—Trade credit, like other forms of credit, is based upon mutual confidence. It is less formal, however, than other forms of credit, especially in the case of the open ac count. The order for goods perhaps does not state
the price or the terms of payment, and the shipment is followed by a mere memorandum in the form of an invoice to the purchaser, stating the usual terms of payment and the cash discount which may be deducted for prompt remittance.
Ostensibly, there is something more behind this form of credit than mere confidence. It is the good will which the seller obtains thru this courteous and informal treatment of the customer's business. In other words, trade credit in the form of open accounts may be considered by the seller in the light of capital employed to finance the selling end of the business. It is a form of advertising, this is why it is now so hard for the Federal Reserve Board to reintroduce into our domestic trade the general use of the trade accept ance, in place of the open account. The open account, promissory note and trade acceptance appear on the balance sheet as quick assets of the seller and as short term liabilities of the buyer.
5. Advantages of credit instruments.—When the credit is evidenced by a note or acceptance, the seller may indorse the instrument and discount it at the bank, which amounts to nothing more or less than a sale of an asset of the company and the creation of a contingent liability by reason of the indorsement thereon. The instrument will be purchased by the bank at a discount from its face value, representing the interest which the bank deducts for advancing the funds until the date of maturity. If it is the first time the instrument has been thus sold, it is called a dis count; if discounted more than once, the process is called rediscounting. In emergency, as we shall see later, open accounts may be discounted, but in a dif ferent manner.
It is customary abroad and in Canada, and in some lines of business in the United States, for the seller to draw upon the purchaser for the amount of the in voice. This draft is presented to the purchaser for acceptance, usually thru a bank. If the purchaser has received the goods in satisfactory condition and is will ing to pay the account, he will probably write his acceptance upon the draft. This acceptance has the effect of an acknowledgment of the account and a promise to pay the draft upon presentation in accord ance with its terms. The acceptance is then returned to the seller, who either holds it until maturity and presents it for collection, or discounts it at his bank.