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.
The distinction between "quick" assets and "working" assets has already been noted (Chapter XVI). We can go a step farther and make a like distinction between cash and other quick assets; under the latter classification are to be included accounts and notes receivable that mature within a few days and merchandise which is already sold or is readily salable for cash. The only asset that is acceptable in settling bills is cash, but other quick assets may be counted as almost equivalent to cash.
Those current assets which are convertible into cash only after a considerable lapse of time or after considerable effort, belong in a different category. It is dangerous to count on them as if they were cash, for numerous contingencies may interfere with their being converted into ready cash at the time that has been anticipated. Many a merchant has found himself suddenly face to face with bankruptcy because he counted merchandise on his shelves as if it were already sold and later found it to be unsalable; or because he looked upon accounts receivable on his books as if they were already collected and later found that some of his important customers were themselves embarrassed or were "slow pay." It is because these contingencies exist, that it is necessary in the prudent management of most business concerns to maintain current assets at an aggregate figure considerably exceeding current liabilities. In manufacturing concerns, as we have seen, the current assets are usually regarded as normal if they are 125 to 133% of current liabilities.
The more readily the current assets of a corporation are convertible into cash, the less need be the proportion of current assets to current liabilities; or, to state the same thing in other terms, the less need be the working capital of the concern. It is clear that if working assets consist exclusively of cash, all the requirements of safety would be met if these assets were equal to the current liabilities. In other words, a concern with perfectly liquid working assets, need have no working capital. The nearer a company approaches to this condition, the smaller is its requirement of working capital; consequently, it follows that any measures which can be taken to increase the liquidity of such assets as inventories and accounts receivable will make possible a corresponding saving in the sum that must be set aside for working capital.
There is no method of increasing the liquidity of stocks of merchandise except care in manufacturing or in purchasing only stocks that are readily salable. No one outside the business itself can be of much assistance in securing this result. Accounts receivable, however, constitute an asset that can be transferred and, inasmuch as most of these accounts are automatically at some later date converted into cash they furnish an excellent collateral for preliminary advances of cash.
Within recent years a large business has been built up by a number of financing corporations which make it their chief business to make advances against instalment accounts receivable and commercial accounts receivable, thus enabling the firm which owns such accounts to convert them wholly or partially into cash before they have come to maturity.
In European practice financing corporations of this type are unknown and unnecessary, for most sales of merchandise are represented by accepted drafts (more commonly known as "trade acceptances") which the selling firm may discount at its own bank or may sell in the open market. In the United States, however, the custom prevails of granting "lines of credit" at banks; these lines of credit are based in large part on the concerns' showing of a satisfactory proportion of working assets to current liabilities and the bank does not favor any method of anticipating the normal conversion of current assets into cash or of pledging any of the current assets. It has, in fact, grown to be an accepted principle, which many bankers perhaps fail to apply with sufficient discretion, that all current assets must be kept free and unincumbered; otherwise the bank will not care to extend credit.
In spite of opposition on the part of the banks, the financing corporations have rapidly increased the volume and raised the character of their dealings. Moreover, certain banks and trust companies have gradually come to carry on a limited amount of business of the same type.
There are two distinct fields of operation for the financing corporations that have been referred to, and they are readily divisible into two corresponding groups: The first group confines itself almost entirely to making advances against instalment accounts receivable, and the second group into making advances against commercial accounts receivable. The chief kinds of instalment accounts handled in this manner are those which arise in connection with the sale of agricultural machinery, pianos, and other musical instruments. Both these lines of business are conducted by large and well-established corporations which do a national business, in some instances making sales direct to consumers and in others making sales through dealers to whom they frequently give assistance in financing their business. For reasons that have been fully explained above, the amount of capital that would be required to finance an instalment business of any size would be prohibitive to most retail dealers if they were to work unassisted. Publishing companies which sell dictionaries, encyclopedias, and other sets of books, payment for which is made by instalments, also frequently secure advances, using their accounts receivable as collateral; for various reasons, however, this class of instalment accounts is not ordinarily regarded with so much favor as the other classes that have been mentioned. As typical of the manner in which the financing corporations that handle instalment accounts operate, we may take the published description issued by the Commercial Security Company of New York and Chicago, which makes advances on the strength of notes, mortgages, and leases given by purchasers of pianos to dealers and manufacturers. The company deals only with concerns which furnish satisfactory financial statements and have a good commercial rating. This concern must guarantee all the instalment accounts, leases, or notes which are assigned to the Commercial Security Company as collateral. The accounts (which may be in the form of leases or of notes secured by mortgages) are not actually taken over by the Commercial Security Company, but are left in charge of some one in the employ of the dealer or the manufacturer who is authorized to make collections and who is bonded to make prompt payment of the proceeds to the Security Company; the former custom of transferring the accounts bodily to the financing corporation which made its own collection has proved objectionable and has been almost entirely abandoned. The Commercial Security Company requires that final instalments on the paper which it accepts as collateral must mature within 31 months, and that at least 20% of the price of the piano must have been paid, leaving 80% of the price to be collected. Against this balance the Commercial Security Company makes advances to the extent of 80%; in other words, the maximum advances are equivalent to 64%, of the retail price of the pianos. The Commercial Security Company then deposits the paper which it has accepted as collateral, with certain designated trust companies in New York and Chicago, and issues its own 6% bonds up to 80% of the face value of the paper which it has deposited. These bonds (which might better be called "serial notes") are issued in series of $100,000, $10,000 maturing every three months, so that each issue is paid out within 2 1/2 years. The bonds are sold to banks and to the general public, and are said to be well regarded as a good type of short-terms notes.
The Agricultural Credit Company, which was incorporated in New York in 1912, operates along much the same lines, except that it specializes in the notes or other obligations given in payment for agricultural implements. A number of other companies might be mentioned.
In making advances on commercial accounts receivable, the Manufacturers' Commercial Company of New York follows much the same plan that has just been described. This company purchases the accounts receivable of mercantile firms and deposits the paper which it purchases with a trust company as collateral for its own issues of collateral trust certificates. These certificates bear 5% interest, maturing in from 30 days to one year, and are in amounts of $100 or any multiple thereof. They are sold both to banks and to private investors. The company carries a 20% margin of collateral. On April 1, 1914, according to the company's published statement, the total collateral held by the trust was in excess of $800,000 based on 1,073 accounts, showing an average amount of $795.22 in each account. The company features the widespread distribution of risk due to the small sum represented by each account. Most of the. financing corporations, however, which handle commercial accounts receivable, themselves reassign the paper which they take over, with their own indorsement, to the banks with which they do business. They make a point of the fact that accounts or notes can be assigned and yet the collections may remain in the hands of their clients, thus insuring that the assignment is kept confidential.
The Commercial Credit Company of Baltimore advertises that manufacturers and jobbers may sell to them $200,000 of notes during any year, at a total cost of $2,500, provided they are paid within 30 days. Inasmuch as this is at the rate of 1% per month, plus a commission charge of 1/2 % on the first $100,000 of accounts, it is clear that the rate of discount which the manufacturer or jobber must pay is high; yet the accommodation that he receives may be well worth the discount.
These companies usually loan up to about 75 to 80% of the face value of the paper which they accept as collateral. Sometimes a fixed line of credit is granted to a client, against which a corresponding amount of collateral is constantly maintained (paid or bad accounts being continually replaced by fresh ones), and sometimes a separate loan is made against each given block of collateral, each loan being regarded as a new and distinct transaction.