Generally speaking, there is no sounder method of extending the capital of a manufacturing or mercan tile enterprise, whether a corporation or not, than by the use of trade credit, especially when in the form of notes and bills available for discount. The term "bill," as here used, means "bill of exchange." In do mestic use it is known as a draft, in foreign trade, as a bill of exchange. It is evident that, if any company obtains more trade credit than it, in turn, extends to its customers, it is obtaining to that extent the free use of borrowed capital. This is the first and most ad vantageous source of corporate borrowing.
6. How banks assist in extending trade credit.— Commercial banks cannot properly make loans or dis counts except for short periods of time, usually not over ninety days or four months, and this should cover transactions which involve the production and distri bution of products or services in the ordinary course of trade.
This is recognized in the Federal Reserve Act, which vests in the Federal Reserve Board the power to define the kind of papers which Federal Reserve Banks may rediscount for member banks. The Fed eral Reserve Board defined such paper in the follow ing words: The limitations relating to rediscount operations, con tained in section 13 of the Act, may be divided into two classes : First, those positive limitations under which such notes, drafts, and bills of exchange may be accepted for re discount ; and, second, those limitations specifically stating what paper shall be excluded.
If we begin with the latter, we find the very clear provision excluding all notes, drafts and bills of exchange which are "issued or drawn for the purpose of carrying or trading in stocks, bonds or other investment securities (except bonds and notes of the Government of the United States)." This clause does not require comment.
The Act further excludes notes, drafts and bills of ex change covering "merely investments." Any funds employed in agriculture, commerce or industry are quasi investments, and the emphasis is, therefore, to be laid on the word "merely" in this connection.
From this point of view are to be excluded all bills whose proceeds have been or are to be used in permanent or fixed investments of any kind. "Agricultural, industrial or com mercial purposes" can not, therefore, be held to include in vestments in land, plant, machinery, permanent improve ments or transactions of a similar nature.
The purchase of commodities for purposes which are merely speculative and not connected with an ultimate process of manufacturing or distribution would constitute a "mere" in vestment, and bills covering such investments are accordingly not eligible for rediscount.
In order to be eligible for rediscount, bills must "arise out of actual commercial transactions," and "the proceeds must have been used or they are to be used for agricultural, indus trial or commercial purposes." In like manner "notes, drafts and bills of exchange se cured by staple agricultural products or other goods, wares or merchandise" are eligible for rediscount provided they arise out of "actual commercial transactions" covering some particular stage in the process of production and distribu tion.
They are not eligible when drawn to cover merely specula tive investments.
It is plain from the above why notes and accept ances arising in the extension of trade credit con stitute the finest possible investment for commercial banks. To the seller they are much safer and quicker assets than open accounts by reason of this bank de mand.
7. Trade credit not used for permanent invest ments.—Trade credit should not be depended upon, however, to provide funds for permanent investment, as in lands, buildings and machinery, for the simple reason that such assets cannot well be sold to liquidate the credit when due. Trade credits are nearly always for short periods and are ordinarily expected to be self-liquidating; that is, the buyer is expected to con vert the goods into cash in time to pay the open ac count, acceptance or note which he assumed when he purchased the goods.
Just to the extent that transactions involving trade credit are not self-liquidating, the buyer is compelled to make payment out of funds procured from one or more of the following other sources: Profits of the business Bank loans The sale of bonds The sale of capital stock Sacrifice sale of assets.
No business can be expected to make money rapidly enough to pay for permanent assets out of profits earned during the brief interval for which trade credit is ordinarily granted. Neither is it usually safe to depend upon the anticipated sale of stock and bonds to meet trade obligations. It takes time to authorize, issue and sell securities, and the trade credit of any concern should not hang upon such a slender pos sibility as an emergency sale of securities. Pending the sale of security issues, which have been previously authorized and their sale provided for, trade credit or . bank loans may sometimes be relied upon to finance permanent investments. As a principle of finance, however, it is a risky practice to depend upon trade credit or bank loans to finance such investments, or even unusual seasonal requirements, unless the com pany has remaining a liberal excess of quick assets over its short term liabilities.