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Home -> Neil H. Jacoby -> Business Finance And Banking -> Part 1 Chapter 1

Business Finance And Banking - Part 1 Chapter 1

1. Preface

2. Summary

3. Part 1 Chapter 1

4. Chapter 2

5. Part 2 Chapter 1

6. Chapter 1 - continue

7. Chapter 2

8. Chapter 3

9. Chapter 3 continue

10. Chapter 4

11. Part 3 Chapter 1

12. Part 4 Chapter 1


Chapter i


CHANGES SINCE 1900 IN the credit market serving nonfinancial
business, excluding agriculture, can be described most effectively
when related to conditions in a specific recent year. Furthermore, a
study of the relationships between business characteristics and the
use of credit in a certain year yields suggestions as to the features of
the business credit market which should be examined for evidence
of change, and it also provides a basis for weighing the importance
of any changes that may be found. A base year that is particularly
appropriate for the present study is 1940. By that time the effects
of the depression of the thirties on the business community and its
credit demands could be appraised j in addition, economic conditions
in the United States had not been distorted to any great extent by
World War II. This chapter, therefore, outlines the composition
of American business around 1940, and its asset and liability struc-
ture and financial policy as they affect the demands of business for
credit. The succeeding chapter measures both the short-term and
long-term elements in the supply of credit at that time, and indi-
cates the role of the commercial bank in the credit supplying process.


At the outbreak of World War II there were about 3.4 million
independent nonfinancial business enterprises in the United States,
of which nearly I million were one-man owner-operated ventures.
Their consolidated total assets, including net ownership or creditor-
ship claims upon consumers, governments, agriculture, and financial
institutions, as well as tangible assets, amounted to more than $166
Among the major industrial divisions, manufac-
turing had the largest fraction of personnel and
value of product, public utilities the largest share
of tangible property and total assets, and retailing
the largest number of concerns.


billion. These enterprises provided a livelihood for more than
half of the 46 million people who were gainfully employed,
although they formed only about one-third of the total number
of private undertakings in the nation; the six million farm enter-
prises accounted for the remaining two-thirds. Chart i describes the
industrial composition of the nonfinancial business community at
the beginning of the war period, in terms of number of personnel
employed, value of output, value of tangible property, total assets,
and number of concerns. 1

CERN, I939 a

(dollar figures in thousands)

Manu- Wholesale Retail Con-
Asset Size facturing Trade Trade struction Service Total
Under $250
a Estimates of the National Bureau of Economic Research, Financial Research Pro-
gram, based on data from U. S. Department of Commerce, Bureau of the Census, Cen-
sus of Business, 1939 and U. S. Treasury Department, Statistics of Income for 1939*
Part 2.

b Less than one-tenth of one percent.

The nonfinancial business community was made up of a vast
number of small concerns and relatively few large ones whether
size is measured by the total assets a business employs, by the num-
ber of its employees, or by the annual volume of its sales. For a
study of the financing of businesses, it is convenient to group enter-
prises into size classes according to the amount of their total assets.
Therefore in this study, unless otherwise indicated, "small" busi-
nesses will mean concerns with total assets under $250 thousand}
"medium-sized" businesses, those with total assets of $250 thou-
sand to $5 million; and "large" businesses, those with total assets of
$5 million and over. A fourth category of "very small" businesses
with total assets under $50 thousand may be useful for some pur-
poses. The predominance of the small concern among the total
number of business enterprises is indicated by the estimates for
1939 presented in Table i.




Examination of concerns of varying asset size reveals that the
profitability of business, measured by the average rate of return on
the equity of owners, becomes progressively higher as asset size of
business increases. After studying the relation between corporate
size and earning power during the period 1931-36, Professor
W. L. Crum concluded that "on the average, large enterprise
in all or nearly all broad lines of industry, and in different stages
of the economic cycle is more profitable than small enterprise,
especially very small enterprise." When unprofitable enterprises
were separated from profitable ventures, however, the range of
profitability and unprofitability diminished with striking consist-
ency as corporate size increased. In other words, both the highest
profit rates and the highest deficit rates were found among small
concerns. 2 In many cases big business is really an agglomeration
of numerous small ventures whose successes and failures average
out into a comparatively narrow range of profitability.

The relationship between size and profitability, shown in Chart
2, emphasizes two features of the business credit market. First, the
erosion of funds as a result of operating losses, which gives rise to
urgent and persistent financing demands, was relatively most im-
portant among small and medium-sized enterprises. Second, the
enormous range in operating results among small concerns, due in
part to their large number, and the greater temporal instability in
the earning power of individual small concerns, made the risks of
lending to small and medium-sized businesses many times greater
than those of lending to large enterprise.

Total Assets
(in thousands)

Under $50

50 - 100

100 - 250

250 - 500

500 - 1,000

1,000 - 5,000

5,000 ~ 10,000

10,000 - 50,000

50,000 - 100,000

100,000 and Over

All Corporations
As asset size of business increased, the range of profitability and
unprofitability diminished. Both the highest profit rates and the
highest deficit rates were found among small concerns. For in-
come and deficit corporations combined, the average rate of
profitability improved as size increased.


Another factor of significance to the business credit market is the
rapidity with which the business population changes through time.
Estimates indicate that the number of completely new business con-
cerns established each year during the period 1936 through 1940
averaged 160,000, although an additional 270,000 concerns
annually acquired some element of newness through succession


or extension of operations. 8 In view of the negligible changes in the
total number of business enterprises between 1925 and 1940, the
over-all average "life expectancy" of a completely new American
business at that time could be put at about fourteen years. But this
average means little because of vast differences between the "life
expectancies" of old and large enterprises, on the one hand, and
new and small ones, on the other. Scattered studies indicate that
approximately one-quarter to one-half of all new ventures in
various retailing lines discontinue operations within a year after
starting} they also reveal that average life increases steadily with
size in all industries. 4 The high rate of turnover among small enter-
prises largely explains why special techniques of credit extension
are applied in meeting their credit demands. It means that lenders
frequently take liens on assets or apply other methods of assuring
repayment of loans in the event of unexpected discontinuance.


The types of assets held by nonfinancial business concerns strongly
influence the amount and kind of their demands for credit. When
all assets are divided, for convenience, into the three categories of
fixed assets (including land, plant, and equipment), investments in
other companies, and current assets (including cash and equivalent,
receivables, and inventory), certain broad features of asset structure
around 1940 may be noted. 5 No "normal" or typical pattern of
assets for all business enterprises is apparent, but there were charac-
teristic asset structures for businesses of particular industries, sizes,
and degrees of profitability.

Of prime importance are the ratios of fixed and of current assets
to total assets. 6 In 1939 the fixed assets of all nonfinancial concerns

8 Alfred R. Oxenfeldt, New Firms and Free Enterprise: Pre-War and Post-War
Aspects (Washington, 1943) p. 4.8.

4 Ibid., pp. 174, 176-

5 For an extensive analysis of corporate financial structure, based on 1937 data, see
Walter A. Chudson, The Pattern of Corporate Financial Structure: A Cross-Section
View of Manufacturing, Mining, Trade, and Construction, 1937 (National Bureau of
Economic Research, Financial Research Program, 1945). This section relies heavily on
Dr. Chudson's analysis.

9 It must be recognized that the dollar values of fixed assets on the books of business
corporations often do not measure the present worth of fixed assets vis-a-vis current
assets, because of property write-ups and write-downs, changes in the price level, and
other factors.


(on an unconsolidated basis and excluding agriculture) constituted
53 percent of their total assets, with the ratio of fixed to total assets
varying considerably among the major industrial divisions. (See
Chart 3.) For manufacturing concerns the ratio was 37 percent, for
retail trade concerns 26 percent, and for wholesale trade 10 per-
cent, while in certain other divisions of business, notably public
utilities (including railroads), the importance of fixed assets was
much greater. As size of business increased, fixed assets as a pro-
portion of total assets became more important, and current assets
less important.

Investments in other companies, like fixed assets, increased in
relative importance with size of business (Chart 3). The concentra-
tion of investments among business corporations of large size may
indicate, among other things, that large businesses tend to finance
the needs for long-term funds of other businesses, including small
firms, just as they provide much short-term credit to small concerns
through the medium of accounts receivable.

Cash and its equivalent (marketable securities) is universally a
major item among business assets. Trading concerns understand-
ably carry a larger proportion of their total resources in cash than
do manufacturing or public utility concerns. The ratio of cash to
total assets falls with size of business, measured in total assets, but
when marketable securities are added to cash, the ratio for the com-
bined total varies only slightly as corporate size increases. When
corporate size is measured by annual sales, there is a distinct ten-
dency for the larger concerns to hold greater fractions of their
assets in the form of cash and its equivalent.

Accounts receivable are among the most liquid and therefore the
most bankable of business assets. At the end of 1939 nonfinancial
business corporations as a group had $ 1 5.0 billion of receivables and
only $i 1.4 billion of payables outstanding, showing that they were
extending $3.6 billion of net trade credit to unincorporated busi-
nesses and to consumers. While the receivables/sales ratios of the
various industries differed widely, they were generally higher in
the producers' goods industries than in the consumers' goods indus-

Inventory also is a highly bankable current asset. Ratios of in-
ventory to either sales or total assets varied considerably among
industries, but they were relatively high in manufacturing and in
Fixed assets in 1939 were a major fraction of total assets in
the public utility, mining, and service divisions. Current assets
comprised the greatest proportion of total assets in manufac-
turing, wholesaling, retailing, and construction. For busi-
ness as a whole, the relative importance of fixed assets in-
creased with size of business.


trade, industrial divisions that hold the preponderance of all inven-
tory of the economy. The ratio of inventory to sales for most manu-
facturing industries exhibited a marked and consistent tendency to
rise with corporate size, reflecting the tendency for big business, be-
cause it usually combines a number of production processes under
one management, to turn over its inventory more slowly than small

In summary the available data indicate that the asset structure
of the major industries varied considerably in the period preceding
World War II. Further, when concerns of different size are com-
pared, fixed assets and investments are found to have been of more
importance and current assets of less importance as size increased.
As a consequence, the credit demands of large concerns tended to
be greater, relatively, for long-term than for short-term funds. A
broad picture of these variations is afforded by the data presented
in Table 2.


The funds employed in a business enterprise are either owned or
borrowed. The debt of a business represents dollar claims of definite
amount against the income and assets of the business, while the
equities represent the remaining values in the enterprise belonging
to the owners. The amount of risk borne by the two classes of claim-
ants differs considerably, that carried by the owners being the
greater. Some investment by owners is clearly essential to business
birth and is generally an indispensable condition to the incurrence
of debt. Lacking equity, a business could not provide to creditors
that preferred position in the scale of risks which is the very essence
of creditorship. 7

At the outbreak of World War II, as in the entire period 1900*
1940, ownership capital claimed the preponderance of business
assets. No less than 62 percent of the total assets employed by all
nonfinancial business corporations (excluding agriculture) was fi-
nanced with ownership funds, and only 38 percent with debt funds
at the end of 1939. Comparable information is not available for

7 In unusual cases an established business may have no net worth, and still may oper-
ate profitably. But it is scarcely likely that a concern can contract a new loan without
possessing some ownership values.
unincorporated businesses, but sample data show that the average
proportion of equity for them was greater than for corporations,
in part reflecting the fact that these businesses are principally small
and very small concerns for which the ratio of equity to total assets
is typically high. 8 Broadly speaking, for each dollar of credit it
demanded, business management sought about two dollars of
ownership capital. Ownership funds were more than equivalent to
the total investments of businesses in fixed assets, and covered a
substantial portion of their current assets.

Among major industrial divisions there were stable and clear-
cut differences in the relative importance of debt. In manufacturing,
debt comprised about 25 percent of total liabilities in 1939; in retail
and wholesale trade, it formed about 35 and 45 percent, respec-
tively; in construction, it amounted to about 50 percent; in public
utilities (including railroads) and in the service industries it com-
prised more than half of all liabilities (Chart 4).

The size of a business also was a major determinant of its rela-
tive use of equity and debt financing. Among the asset-size classes
shown in Chart 4, the highest indebtedness in proportion to total
assets in 1939 is found in the class of concerns with total assets of
less than $250 thousand. Broadly speaking, ownership was large
and debt was small for very small enterprises (i.e., those with total
assets of less than $50 thousand, not shown separately in Chart 4)
and for large enterprises other than public utilities. Breadth of
access to financial markets is an important factor in explaining this
behavior. Very small concerns may have high fractions of equity
simply because they are unable to borrow, are unwilling to borrow
on the credit terms available to them, or have no desire to expand.
Small and medium-sized concerns (with assets from $50 thousand
to $5 million), having greater accessibility to credit than to equity
funds, are more likely to finance their activities through loans.
Large businesses can make public offerings of equity securities
readily, and in addition they have a higher and more stable aver-
age profitability which enables them to build up equity and pay off
debt by retaining earnings in the enterprise. Another reason for the
greater importance of equity in businesses of large size may be the
For corporate business as a whole, net worth at the outbreak
of World War II was the preponderant source of funds. In
the public utility and service industries, however, debt ac-
counted for the major fraction of funds.



direct correlation between size and age of enterprises) large busi-
nesses, being older, may have relatively more equity funds simply
because they have had more time to accumulate equity through
retention of earnings than have smaller concerns.

Profitability of business has affected its use of credit to an
important degree. Profitable concerns have had much lower ratios
of debt to total assets than have unprofitable concerns. In 1939 the
profitable concerns in every major industrial division were 15 to
30 percent less indebted than were unprofitable businesses of the
same size (Chart 5). The current liabilities of unprofitable con-
cerns as a whole were substantially greater in relation to both total
assets and sales than were those of the profitable ones, both their
borrowings and their accrued liabilities being heavier. Invested










vlncludinj Railroads


In every major division of industry in 1939, income corporations had
less indebtedness in proportion to their total assets than did deficit cor-


capital formed a definitely smaller proportion of total liabilities
of the unprofitable concerns, a condition resulting almost wholly
from the smaller proportion of surplus accumulated by them. These
findings are in no wise peculiar to 1939 or 1940. It is a matter of
common observation that when the profitability of a business con-
cern declines, its trade payables are allowed to rise and its bank
loans are renewed rather than paid off. When operating losses occur
they reduce the owners 5 equities, thus enlarging, on a relative scale,
the indebtedness of the business. In either case a higher ratio of debt
to equity emerges as a more or less automatic or passive response to
the situation. The fact that owned funds play a more important
role in large and in profitable enterprises than in moderately small
or in unprofitable ones also reflects in part the high degree of direct
association between size and profitability a relationship that was
commented on above.


What determines the relationship between debt and equity funds
in a business managed so that profits to owners will be maximized?
Theoretically, the assets a business could profitably employ
would be acquired with borrowed money up to the point where the
interest rate on the last increment of debt equaled the rate of profit
realized from employing these funds in the enterprise. In other
words, credit would be used in a business so long as it could be ob-
tained more cheaply than equity funds.

This familiar principle of "trading on the equity" does not pro-
vide a complete and realistic description of entrepreneurial behavior
around 1940. Businessmen did, of course, make comparisons be-
tween the expected payments they would have to make on new
equity funds and those they would have to make for loans, in de-
termining how they should obtain new funds. But other factors
generally appear to have weighed more heavily in their decisions.
In nearly all businesses the fluctuations of earnings and the prob-
abilities of loss were difficult to evaluate quantitatively, but losses
could cause the fixed charges of debt to become embarrassing. As a
result, management in many cases apparently had developed a
predisposition against borrowing which often produced a struc-
ture of liabilities that could not be explained merely by reference to


cost differentials. Borrowing particularly on short term was
regarded as a seasonal or emergency measure, and not as a normal
and continuing source of funds. Furthermore, standards of pru-
dence in lending required that a margin of equity funds be present
in the financial structure of a potential borrowing concern.

Apart from this, the institutional structure and traditions of fi-
nance bore heavily upon the equity-debt relationship. Many con-
cerns desired equity funds, but found the equity securities markets
closed to them or accessible only on terms they could not profitably
accept, and they utilized credit for lack of an alternative. Enter-
prises with large fixed properties, such as railroad and public utility
concerns, even when they could obtain equity funds, pursued a
tradition accepted by financial institutions of borrowing substantial
percentages of the appraised value of these properties against mort-
gages. During the period between the two world wars, many rail-
roads could not lawfully sell additional stock, because their out-
standing equity securities sold for less than their par values. Con-
sequently, they were compelled to borrow the funds they needed.
The anticipations of entrepreneurs and investors regarding the fu-
ture earnings of a concern also affected the nature of its financing.
Federal taxation strongly influenced the choice between debt and
equity funds, generally favoring the incurrence of debt because
interest was a business expense deductible from taxable income,
while dividends were not. Large concerns had a wide range of op-
tions in adjusting their financial structure to these conditions, a fact
which is reflected by data showing that the complexity of corporate
financial structure increases with business size. 9 In summary, no
simple statement can encompass all the forces that determined the
division of the liabilities of businesses of different types and sizes
between creditors and owners in 1 940.

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