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.
Sometimes circumstances arise which justify the directors of a corporation, in their opinion, in borrowing the money with which to pay dividends. This is, in fact, quite frequently the case with companies which have to contend with wide seasonal fluctuations and with companies which normally operate with a small working capital.. As has previously been pointed out, transportation and communication enterprises frequently belong in this last-named group. Commenting on numerous cuts in the dividends of railway corporations, the London Financial Times of October 2, 1914, says editorially:
It is necessary to be guided by the amount of cash actually in the till. Borrowing on temporary loans from one's bankers in order to make up the heavy amount of ready cash required to pay dividends - a common and perfectly proper procedure in normal times - is much less desirable under existing financial conditions.
For companies of the two types just referred to, it may be sound policy at times to pay dividends with the proceeds of temporary bank loans - assuming, of course, that there can be no reasonable question as to the company's ability to repay these loans without crippling itself. There is a great distinction, however, between this situation and that which exists when a corporation issues long-term obligations or when it sells additional stock in order to obtain money with which to pay dividends. If a corporation were to follow this practice during a period when it was not actually making a legitimate showing of profits, it would be clearly engaged in a fraudulent transaction. When it issues long-term obligations or sells additional stock during a period of adequate profits or for the purpose of paying dividends that are charged against accumulated surplus, its course of action is not necessarily fraudulent, but it is certainly open to serious question as to its essential soundness.
A case which aroused a great deal of discussion in financial circles occurred in 1913, when the management of the American Can Company decided that the time had arrived when it was advisable to pay up a portion of the dividend claims on its preferred stock issue which had been accumulating over a period of several years. The company sold an issue of $14,000,000 5% debenture bonds and with the cash proceeds paid a 24% dividend on preferred stock. The consensus of opinion among conservative judges, it may safely be said, was that it would have been far wiser to have paid off the arrears of preferred dividends gradually out of profits as they accumulated. Although it is true that this plan would have involved deferring common dividends for a period of years, it would have put the company eventually into a position of undoubted financial strength.