Speaking on "Banking in Canada" before the Lon don Institute of Bankers some years ago, Sir Edmund Walker, president of the Canadian Bank of Com merce, said: . . . our policy is to lend by established credits only the money necessary to produce and carry the merchandise to market. Now if a customer deals with only one bank, pays for all materials and labor in cash, makes all payments by checks on his bank, exhibits his balance sheet and profits, and at the same time discusses at length the various features of his business for the purpose of having his credit reestab lished, it is not difficult to lend him very large sums with safety. In addition to the analysis of the balance sheet, comparisons are made with several for previous years . . . all except the quite small credits are discussed with the boards of directors.
14. Purposes of short-term loans.—Enough has been said to indicate the true purpose and safe ex tent of short term borrowing, whether from trade credit, bank loans, or the sale of short-term obligations to the public. This latter class of notes will be dealt with in another chapter. Before leaving the subject of bank loans, however, a review of the specific pur poses for which they may be made is necessary. Ex ceptions may be taken to this list, or additions made to it, but in general it will be found correct: (a) To produce, ship, store, sell and collect for the regular product of the business, when there is reason able certainty of turning the transaction in time to repay the loan.
(b) For current or capital expenditures pending the receipt of funds from the sale of stock or bonds which have been underwritten, and the proceeds of which are expected in time to liquidate the temporary loan.
(c) To carry unusual seasonal stocks, production or accounts receivable which will ordinarily be liqui dated in time to repay the loan or amply secure its partial renewal.
(d) To pay dividends which have been earned but are temporarily locked up in assets that will be nor mally liquidated in time to repay the loan.
To illustrate; a corporation was formed with an authorized capitalization of $500,000, of which $200, 000 was seven per cent cumulative preferred, the bal ance common stock. The promoter subscribed the common stock and paid for it in cash at par. He was a successful business man, highly rated, and enjoying at the banks perhaps the highest personal credit of any man in the community. The purpose of the new company was to manufacture and sell unfermented grape juice.
The plant was built and equipped at a cost of $250, 000, out of funds provided by the sale of the common stock. The preferred stock was relied upon to fur nish working capital. It was sold to New York parties who agreed to take it up and pay for it the following September in time to purchase the grapes for the fall pressing.
When the time came to deliver the preferred stock, it was found that the underwriters had suffered re verses which rendered it impossible for them to take the stock. Something had to be done quickly. If
the grapes were not purchased and pressed within the next thirty days, the plant would have to lie idle for an entire year, awaiting the next crop. These funds could only be provided by the sale of the preferred stock, or by the sale of bonds, or by short-term bank loans.
The plant was situated in a country town and con sequently had but little bonding value. Furthermore, the original financial plan did not contemplate the issue of bonds, and there was neither time nor desire to resort to them. It was impossible to sell the preferred stock in the short time remaining. Local bankers were consulted and agreed to advance the required funds pending the sale of the preferred stock so that the company could go ahead with its operations. Among others, a trust company in New York City advanced $50,000. The plan was to renew the loans for ninety days upon maturity, pay off half at the second ma turity, and the balance ninety days later. It was cal culated that the company could do this out of current income, meanwhile selling the preferred stock to se cure its permanent working capital.
Before reading the next paragraph, how many readers see the flaw in the plan thus far? Everything progressed well until almost time for the second renewal. Then the trust company failed, and the Banking Department of New York State, which took charge of the bank, refused to renew. Meanwhile, the preferred stock had not been sold, but the business of the company was better than had been anticipated. It became plain that the banks would not only have to renew again for the full amount as agreed, but carry the share of the trust company as well. This they refused to do unless given control of the company pending the repayment of their ad vances. An actual audit and inventory was then taken by certified accountants engaged by the bankers which showed an excess of $185,000 in assets above all liabilities, after writing off ample depreciation upon goods and accounts and the entire value of a good-will which had cost $100,000, and which had resulted in sales aggregating half a million dollars in five months.
Now in control, the bankers preferred themselves as creditors by the issue of bonds, by a process de scribed elsewhere in this Text. Their next step, was to secure the appointment of two of their number as receivers. A few months later the business, which the bankers themselves had valued at $185,000 above all liabilities when they took charge, was wound up by the payment of six per cent to general creditors.
The case is cited in detail to illustrate the danger of relying upon bank loans for capital that should be obtained from the sale of securities, and to illustrate a frequent fate of business concerns which fall into the hands of the banks.