RELATION OF WORKING CAPITAL AND INCOME TO ASSETS 1. Relation of net income to capital stock.—It is a frequent custom in interpreting financial statements to consider that the ratio existing between net income and capital stock is a sure index of the progress of the business. While this ratio discloses the ability, or lack of it, on the part of a corporation to pay a dividend, many overlook the fact that capital stock does not represent the total invested assets of a busi ness. In many.cases, the earnings which a corpora tion discloses in its income statements, are due in no small measure to large surpluses and reserves.
Commenting upon the balance sheets of four of the large Chicago packing companies (Armour, Cudahy, Morris and Swift) a writer made the statement that for the year 1915 the companies had earned over 25 per cent of the total capital of $110,000,000. This statement is true, but let .us analyze the situation a little further for the purpose of determining whether or not it really means anything.
The following table shows the capital stock, sur plus, reserves, bonded debt and current liabilities of each organization as reported for the year 1915: 2. Comments upon the above statement.—It will be noted that the financial plans of each of these organizations differ widely. A comparison of the capital stock account shows that Armour and Morris have raised more capital thru the issue of bonds than thru sale of stock; Cudahy and Swift on the other hand have raised more capital thru an issue of stock than thru the issue of bonded debt. For the purpose of stating the comparison on a more uni form basis, let us consider the following statement, which shows how the capital owned and borrowed is distributed by percentage.
3. Ratio of net income to capital stock.—If we calculate the ratio of net income to capital stock in each of the individual companies, we learn that Armour's earnings for the year 1915 were equivalent to 55 per cent on the capital stock, while the earnings of Cudahy, Morris and Swift were respectively 6 per cent, 77 per cent and 18.8 per cent. When the financial writer made his calculations, he added the earnings of all the companies together and divided by the aggregate of the capital issues to arrive at his percentage of 25.65 per cent. Yet, when we con
sider the earnings of the individual companies with reference to capital stock, we see that the results differ widely and bear no relation to the average determined by the financial writer.
4. Ratio of net income to total invested assets.— It will be obvious that the total capital fund which each of these organizations employed in business, con sists of its total assets. This is the capital fund which was turned over or employed in the business organ ization, and with which these organizations earned their apparently enormous profits. If we calculate the ratio of net income to total assets, we learn that in the case of Armour & Company, the ratio is 5.46•per cent; Cudahy Packing Company, 1.86 per cent; Mor ris & Co., 3.94 per cent. ; Swift & Company, 6.83 per cent. The average for all companies combined is 5.57 per cent.
5. Ratios based on invested assets are the proper ratios to employ.—Comparisons on percentage bases are likely to mislead if the proper basis is not used. Here the more significant comparison is ratio of net income to total assets. The profits under discussion were drawn from a sales turn-over of $425,000,000 for Armour and Company, $500,000,000 for Swift and Company and approximately $116,000,000 for the Cudahy CoMpany. It follows that the percentage of profit on sales is very small, and that an enormous turn-over is necessary to earn the profit made.
Since 1915 the packing companies have increased their outstanding capital stock by approximately $150,000,000 so that the same comparisons cannot be obtained today. For the year ending November 1st, 1919, the earnings on the capital were 10.8 per cent. In passing, it is of interest to note that a comparison of earnings and sales for 1919 with 1915 shows that sales have increased enormously, being $1,038,000,000 for Armour and Company, $306,000,000 for Cudahy Packing Company and $1,200,000,000 for Swift and Company, while earnings in total increased only about $4,400,000, showing that the percentage of earnings to sales has been materially reduced and further emphasizing the importance of turnover.