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.
One of the frequent causes of embarrassment to corporations which take over going concerns, or which are formed in order to combine previously existing concerns, is the discovery that the supposed net earnings of the acquired concern have been achieved through failure to maintain the property in first-class condition. Of course, if the investigation has been sufficiently thorough, this fact will presumably have been discovered. However, the truth is that such investigations frequently are carried on in slipshod fashion, or may even be omitted altogether. Cases are not uncommon where important combinations have been formed on the strength of the unsupported statements of earnings submitted by each of the constituent companies.
When the International Cotton Mills Corporation was organized in 1910 to take over the mills of the old Mount Vernon-Woodberry Company and the Consolidated Cotton Duck Company, it appeared on the surface that sufficient new cash and working capital had been provided. It developed later, however, that the mills acquired were in a dilapidated condition and that much larger sums than had been anticipated were necessary in order to rehabilitate the property. Due to this weakness, the corporation got into difficulties, and a reorganization became necessary in 1913.
Even within a going and apparently successful corporation the same condition may exist. If the direction of affairs is left wholly in the hands of the active officers they will not be over-anxious to disturb their showing of profits by setting aside ample sums to offset depreciation and to maintain the property at its full value. It must be borne in mind that making repairs from time to time is not enough. If competitors are installing new and more efficient machinery, it is not sufficient for the company to keep its old machinery in good repair. At some later date, when the fact becomes known that large amounts are urgently required to bring the property back into first-class condition, both the stockholders and the directors are likely to be loath to give up or even reduce their dividends to atone for the errors of the past. Instead, the idea of raising new capital to provide •for betterments will meet with favor. It will be argued that betterments represent a capital expenditure which may properly be provided through the issuance of fresh securities, but the expenditures now accumulated in a lump should have been met out of profits over a series of years. It is also probable that fresh capital invested in bringing the plant and machinery up to a reasonable degree of efficiency will not materially increase the profits, but will merely have the effect of preserving and restoring the profits the concern has been earning.
The question as to when betterments constitute a legitimate capital expenditure and when they should be met out of earnings, is naturally always debatable. Conservative management tends strongly to decide the question in favor of the second alternative. When it is not so decided, there is always a danger at least of investing fresh capital in a form that will bring little if any returns. The statement is so obvious that no illustration is needed to enforce it. Its importance, however, should not be overlooked. In connection with the subject of distribution of income, the question as to the proper financing of betterments will be discussed at greater length.