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 habit of borrowing," says Hartley Withers, "is a modern invention." There was formerly a custom among all well-ordered governments and business enterprises, of amassing treasure for use in emergencies; without hoarded treasure even the largest owner of property would have been helpless. Today the wisest financial policy is to pile up not treasure, but credit. To be sure, sound credit may require the possession of a certain proportion of gold and securities; but this treasure no longer exists for its own sake so much as for a support and guarantee to credit.
More and more as credit facilities increase and credit machinery works more smoothly, business enterprises are financed with borrowed capital. The great advantages of borrowing are its cheapness and its ease. It is cheaper to borrow than to secure a co-owner or a group of co-owners for a business, because of the greater security that is offered to the lender. To put the same thought in terms of corporate financing, first-class bonds may be sold on a 4, 5, or 6% basis, whereas preferred shares sell on a 6, 7, or 8% basis, and common shares on a still higher basis. Hence, the larger the proportion of capital which the individual or corporation can borrow, the larger is the yield on the owned capital.
Take a very simple illustration. Suppose a corporation with $100,000 capital is regularly earning 10%, or $10,000, a year; let us say that $20,000 of the capital is borrowed at 5%, making the interest payment $1,000. Then the $80,000 of owned capital will have left an income of $9,000, or a little over 11%. Let us now make the assumption that the business is of such a character that $80,000 can be borrowed at 5%, making the annual interest payment $4,000. In that case the $20,000 of owned capital will have left an income of $6,000, or 30%.
We have here an explanation of the profit-making possibilities - when properly financed - of enterprises which yield only a small average return on the invested capital. Most public utility companies, for instance, secure only a moderate yield on their actual investment, but these companies hold properties which can be mortgaged up to a high percentage of their value. Hence, at least one-half the capital is borrowed and the owned capital may obtain very good dividends. According to the Electrical Railway Review, the issued stock of all the electrical railways in the United States for 1912, had a par value of $2,945,000,000, and for 1913, $2,808,000,000, a decrease of $137,000,000. The bonded indebtedness of these companies for 1912 was $2,641,000,000, and for 1913, $2,-814,000,000. We see here not only a large proportion of borrowed capital, but its rapid increase from year to year, with a corresponding decrease in owned capital. The same thing is true of real estate operations. An extreme case is that of a New York corporation known as the "Forty-two Broadway Company," which has a capital stock of $600 and a bonded indebtedness of nearly $5,000,000.
As to the ease of borrowing, it is perhaps sufficient to call attention to the immense quantities of bonds and notes which are continually being issued and sold. Modern efficiency and productivity are piling up wealth at a faster rate than ever before. And the security of property - except as it may be disturbed by tremendous international conflicts - is increasing. Now the first thought of a man who has only a little money is to increase that little, and he is willing to take chances in so doing. For that reason, it is among poor people, and especially poor people of the professional classes, that the swindling promoter finds his easiest victims. But a man who has a comfortable amount of property is looking for safety rather than for increase. Hence, as the average wealth of a country increases, not only is more and more capital released for investment, but a larger proportion of that capital is looking first of all for safe investment. In other words, its owner prefers to lend it rather than to take greater chances as a proprietor or part proprietor.
Another factor working in the same direction, is the piling up of enormous funds held in trust; estates that are being directed by trustees; the funds of life insurance companies; the funds of savings banks and the like. All these trust funds are available only for lending on excellent security. For these reasons a man or a corporation who can put enough owned capital into a substantial enterprise to furnish a reasonable margin of safety, will generally find it a comparatively simple and easy task to borrow the remainder of the needed capital.
What has been said applies more especially to long-term or "funded" borrowing, but much the same statements hold true on short-term borrowing. "Through all business activities," points out the New York Annalist, "there is more capital needed today than used to be needed, but it is wrong to take it for granted that an individual needs to have more money to go into business."*
The explanation for this apparent paradox is to be found in the free use of credit which is a striking characteristic of all present-day business enterprises. Manufacturers, wholesalers, and bankers are always ready to extend credit freely to young men of ability and character. The silk industry is notable for the amount of business that can be done on a very slim margin of capital Raw silk is sold to manufacturers on a credit basis that resembles "memorandum credit" among jewelers. Many factories are rented entire. It is said that in Philadelphia the extensive cotton industry is in large measure carried on in the same way. Lofts with power and machinery are rented; materials are obtained on a credit basis. The United Shoe Machinery Company has for many years made a practice of furnishing its machines only on lease; it does not sell them. In this industry, therefore, a man with large capital has no great advantage, so far as obtaining efficient machinery is concerned, over a man with small capital.
* New York Annalist, April 17, 1914.