This section is from the book "Business Finance", by William Henry Lough. Also available from Amazon: Business Finance, A Practical Study of Financial Management in Private Business Concerns.
It would be useless to give illustrations at this point of corporations which have transgressed the limits of prudence in selling their own obligations to the public, for we shall be dealing with such cases in the later chapters, where financial embarrassments, insolvencies,, and reorganizations are discussed. It is obvious, on the face of it, that a corporation, like an individual, may abuse its credit. The rule of safety in the issuance of funded obligations requires that the corporate income shall at its minimum more than cover the fixed charges, including both interest payments and sinking fund payments if any. The rule of prudence, which should be regarded invariably in connection with the contingent charges assumed when deferred shares or income bonds are issued, is that the corporate income over and above all fixed charges must be ample, under all conditions that can reasonably be anticipated, to cover these contingent charges. The rule of good faith in connection with the issuance and sale of common stock should be that the anticipated income, based upon the probabilities, should be ample to provide in addition to all fixed and contingent charges a reasonable and increasing return on the common shares. We may state this relation in tabular form as follows:
1. Assured income should be more than enough for fixed charges.
2. Additional income anticipated beyond reasonable doubt, should be more than enough to cover contingent charges.
3. Additional probable income should be more than enough to provide a satisfactory yield on common shares.
It is true, of course, that unforeseen occurrences frequently wreck even the soundest and most careful estimates, and that the organizers and financial managers of corporations are not always entitled to severe censure because their plans miscarry. They are clearly entitled to censure, however, if they do not make their estimate of future income with reasonable foresight and conservatism, and if, after having procured sound estimates, they fail to observe the relations above referred to between earnings and security issues.