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 chapters preceding have dealt with such subjects as the financial forms of business enterprises, the various types of shares and of obligations that may be issued, the selection of securities that are adapted to all the needs of the corporation and to the security market, the construction of a correct financial plan, the promotion and initial financing of a new enterprise, the various methods of selling securities and thus raising the capital required, and the principles which determine the investment of that capital in fixed and in working assets. This completes our study of the various stages in the creation and financial organization of a concern. The remaining chapters deal with the management of companies that are already established and with the exploitation and reorganization of companies that are unfortunate or mismanaged.
The first questions that arise in the financial management of a going, profit-making concern have to do with the determination and distribution of its income. The determination of income may be regarded as primarily a problem of accounting, but it is also a financial problem. As was pointed out in Chapter I, the line of distinction between financial and accounting questions is not always to be sharply drawn. We will not be trespassing, then, on the exclusive territory of our friends, the accountants, if we take up for brief review the question of how corporate income is and should be determined.
For purposes of illustration the following two statements of income are reproduced. The first from a recent report of the American Locomotive Company is in the following form:
Gross Income........... | $29,987,438 |
Operating Expenses, Including Manufacture, Maintenance, and Administrative Expenses and Depreciation charge................ | 27,425,187 |
Net Income........... | $2,562,251 |
Interest, Taxes, and Other Fixed Charges.................. | 486,124 |
Surplus for the Year............. | $2,076,127 |
Preferred Dividends............... | 1,750,000 |
Surplus Available as Earnings on Common Stock............. | $326,127 |
Equivalent on Common Stock to.................. | 1.3% |
Dividends on Common Stock............... | ............. |
Carried to Surplus Account............ | $326,127 |
A much more detailed income statement is that of the Union Pacific Railroad Company, which is as follows:
Freight Revenue........... | $59,253,344 |
Passenger Revenue....... | 18,817,047 |
Mail, Express, and All Other Transportation Revenue.... | 6,726,317 |
Incidental Revenue........... | 2,161,587 |
Total Revenue........... | $86,958,295 |
Maintenance of Way and Structures......... | $10,900,925 |
Maintenance of Equipment.......... | 12,101,212 |
Total Maintenance....... | $23,002,137 |
Traffic Expenses............ | 2,061,971 |
Transportation Expenses.......... | 23,108,140 |
Miscellaneous Operations Expenses.......... | 1,313,189 |
General Expenses............ | 2,811,421 |
Transportation for Investment - credit........... | 160,143 |
Total Operating Expenses............. | $52,136,715 |
Taxes............ | 4,641,474 |
Total Operating Expenses and Taxes.......... | $56,778,189 |
Revenues Over Operating Expenses and Taxes............ | $30,180,106 |
Other Operating Income............ | 1,276,138 |
Total Operating Income................. | $31,456,244 |
Fixed and Other Charges.............. | 15,028,285 |
Surplus from Transportation Operations After Deducting all fixed and other charges............... | $16,427,959 |
Income from Investments and Other Sources............ | 11,964,064 |
Total surplus..................... | $28,392,023 |
Less Dividend on Preferred Stock at 4% Per Annum........... | 3,981,740 |
Surplus After Deducting Dividend on Preferred Stock....... | $24,410,283 |
Equivalent on Common Stock to........... | 10.98% |
Amount Required to Pay Dividend on Common Stock at Rate of 8% per Annum.................. | $17,783,328 |
Surplus After Deducting all Fixed and Other Charges and Dividends on Preferred and Common Stock...... | $6,626,955 |
The above examples show the essential steps in calculating income, which are as follows:
1. State gross earnings.
2. Deduct operating or manufacturing expenses, including selling, administrative, maintenance, and depreciation.
3. The result is net earnings from operation.
4. Add income from other sources.
5. The result is total net income.
6. Deduct taxes, interest, rentals, sinking fund charges, and other fixed charges.
7. The result is surplus for the year applicable as earnings on shareholdings.
8. Deduct preferred dividends.
9. Deduct common dividends.
10. The result is surplus from the year's operations to be credited to surplus account.
It seems hardly worth while to point out that income and expenditure are by no means identical with cash receipts and cash disbursements, though this elementary distinction is not always grasped, even by learned judges and lawyers. It has been pointed out, for instance, by an English authority, that among the legal judgments which have been delivered in the courts of the United Kingdom are such absurdities as the following: *
Profits for the year, of course, mean the surplus in receipts after paying expenses and restoring the capital to the position it was in on the 1st of January in that year.
Fixed capital may be sunk and lost and yet the excess of current receipts over current expenses may be applied in payment of a dividend.
It has been only a few years since the Attorney-General of the United States interpreted the law imposing a tax on corporate income, which had just been passed by Congress, as meaning that a tax had been imposed on the cash receipts minus cash disbursements. His decision was promptly overruled, but among accountants it has not been forgotten.
 
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