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.
Another highly important departure in American business practice which involves difficulties of financing and calls for some special consideration, is the growth in the custom of making retail sales of high-priced goods, payments for which are deferred and are made in instalments. This is a practice which already has a wide application and which gives promise of spreading. Originally, "selling on the instalment plan" was confined largely to high-priced sets of books and a few other articles of luxury. At the present time, however, it is the customary plan of sale in such widely separated lines as pianos, suburban real estate, agricultural machinery, courses of instruction, and sewing machines. It is being introduced more and more also in selling clothing, furniture, jewelry, motor cycles, automobiles, and many other articles.
There has been much opposition to this wide-spread use of the instalment plan, on the ground that it leads thousands of imprudent people into buying articles that they do not need and incurring debts which easily grow to be a serious burden. In so far as the instalment plan is used in selling articles of luxury that do not in any way add to the efficiency or the earning power of the buyer, this objection seems to be well founded. It is equally clear, however, that the objection does not apply when the article that is sold tends to increase earning power; for in that case the purchaser is simply making use of his credit, just as every business house should do, in order to enlarge his facilities for carrying on his activities as profitably as possible. He is following the same policy that the railroad follows when it purchases rolling stock on the instalment plan and gives its equipment notes in payment.
However, we need not here enter into any discussion of the social aspects of instalment selling. The only point that really concerns us is the financial problem that confronts the manufacturer or retailer who adopts the instalment plan. Frequently it has been adopted without .the slightest realization, apparently, that any financial problem accompanies it. As a result, hundreds - or more likely thousands - of instalment houses in various lines of business have been wound up in bankruptcy proceedings and the whole method, no matter how it may be applied, has come to be looked upon by bankers with much distrust. Here, again, some discrimination should be used.
The financial difficulty arises out of the simple fact that the whole cost of the product that is being sold, plus the cost of selling and of overhead administration, is paid out before the product is delivered to the customer, whereas payment is received only in small periodic amounts extending usually over several months. In disposing of real estate on the instalment plan, it is not uncommon for payments to be spread over five to ten years or even longer. In selling pianos the payments frequently spread over as long as three years; in selling furniture, agricultural machinery, and the like, the term of payment is customarily about one year.
A secondary financial difficulty arises out of the fact that a certain proportion of the sales will be made to people who cannot, or will not, live up to their contracts. The manufacturer or retailer may then proceed to take back his goods, but they will usually be in a damaged condition. In any case the expense of making and handling the sale and of attempting to collect the instalment payment will have been incurred and cannot be recovered. The expenses and losses of collection together constitute an item that must be carefully calculated and taken into consideration in every instalment business.
The simplest and one of the most common forms of instalment contract is an agreement on the part of the purchaser to pay the fixed price of the article he acquires at the periods and in the amounts agreed upon, in return for which the purchaser obtains full possession of and title to the goods.
The seller under this agreement has practically nothing except an "open account" against the purchaser. He depends largely upon the purchaser's good faith and on the average honesty of the people he is dealing with, which is usually high. It is this last element - the average honesty of his customers - which constitutes the seller's chief protection and chief asset. He may, of course, be able to enforce collection by legal process, and will probably make it his policy to do so whenever a purchaser gives evidence of acting in bad faith; but if he were compelled to make any large proportion of his collections by legal process, he would be out of business in a short time. In spite of its apparent looseness and the heavy risk which the owner of merchandise appears to take whenever he parts with it on such terms, instalment houses that are selling a really meritorious product by proper methods to a good class of people find that they can count with perfect safety on only a small proportion of expenses and losses in making collections.
Where the amount involved in each sale, however, is large, or where it is desirable to reserve as full protection as possible for the selling house in order to satisfy bankers' ideas, two variations - both designed for the protection of the seller - may be introduced. One of these variations consists of retaining title to the property in the hands of the seller until after the agreed price has been paid in full. This is the arrangement when equipment is sold to railroad companies. It is customary in selling pianos, furniture, real estate, and many other high-priced articles. The legal interpretation of what is commonly known as a "lease contract," under which the instalment payments are technically regarded as rental until after the final instalment has been paid, when title passes to the purchaser, varies from one jurisdiction to another. In some states it has been held to be practically the equivalent of a sale and the title is regarded as having passed to the purchaser at the beginning of the transaction. In most jurisdictions, however, the lease form of contract is upheld. Much indignation has been aroused - some of it doubtless justified - at the attitude of some dealers who have sold furniture under lease contracts and at the first sign of default have taken back the furniture and at the same time retained all the payments that have been made by the purchaser. There often seems to be injustice in such procedure; and yet the seller may usually claim with truth that he is actually the chief loser in every such case and it is necessary for him to take drastic action in order to protect himself against fraud.
The second variation is that of requiring the purchaser to give a series of notes covering his instalment payments. This puts the transaction into a much more definite, irrevocable form, and also assists the seller, as we shall see presently, in making his financial arrangements. Where the amount is large - say several hundred dollars or more - it is almost always wise to require the purchaser to give a series of notes. Where the amount of the transaction is small, the difficulty of getting the notes and the annoyance which the customer feels in giving a note for a small amount are drawbacks which are not compensated for by any general increase in the seller's safety. It does not pay to sue for payment of notes of small denomination. Except for a shadowy moral influence, therefore, the instalment seller is not materially better off for having the small notes in his possession than when he simply has on his books an open account against the purchaser.