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.
As has been previously stated, there may be any number of forms of security issues. The more important types have been described in previous chapters, but a few examples may be cited here of instances in which it was desirable to make unusual changes in order to adapt the security to peculiarities in the assets or in the market conditions. English practice runs very strongly toward the issuance of perpetual or irredeemable debentures, the idea being that all the debtor cares for is to have his interest paid regularly, thus giving him a security which is readily marketable. Even the large brewing companies in England, which can hardly be thought to have a business that is beyond all human vicissitudes, have nevertheless issued and sold a large number of these perpetual debentures. In America they are practically unknown and would probably be almost unsalable. In the United States a peculiar security was brought out by a large distilling company some years ago, consisting of a preferred stock issue which was, however,rto be redeemed by the corporation and was secured by a first lien on all the whiskey stored in bond. It was further provided that the holder of a share of preferred stock could, if he chose, take a barrel of whiskey in payment of his claim. Even this ingenious arrangement, it is understood, did not bring about the success of the issue.
There has been very little real planning in the financial development of most corporations. The easy and obvious thing to do is to meet each financial difficulty or problem as it comes along, in the hope that there will be no further problems. Frequently the result is to create a maze of conflicting claims, and to impose obligations upon the corporation which seriously interfere with the normal growth of its credit and lead to loss or even to insolvency.
The financial troubles which frequently come to concerns that are fundamentally sound and prosperous are wholly unnecessary. They could be avoided by a moderate amount of foresight and careful planning. A typical instance is that of a knitting mill in an eastern state which is capitalized at $900,000, $600,000 common and $300,000 7% cumulative preferred stock. The quick assets are $450,000 in excess of its quick liabilities, and the company has a surplus of $500,000. This corporation, like most all other textile concerns, borrows heavily from the banks. It seldom has loans of less than $600,000 outstanding, and frequently they rise to $900,000; the loans are obtained at an average rate of 5 1/2%. The question that has been raised and is now under consideration, is whether it would be desirable to put out an additional $300,000 of 7% preferred stock at par, thus cutting down the bank borrowing.
To this question there is apparently one sound answer. When bank loans of this concern reach their maximum of $900,000, these loans are equivalent to the whole capital stock, and the margin of quick assets is too small for safety. A failure to dispose of the products of the mill on the usual terms and at the usual time might suddenly bring on bankruptcy. The case of the National Cordage Company already cited is in point. Because of its extensive and growing business, the corporation is evidently driving toward a possible financial position of serious danger. It is expected that the directors will shortly take action authorizing the sale of preferred stock and reducing the bank indebtedness by a corresponding amount. The result would be to reduce the earnings on the common stock by approximately $4,500 per year, but this is a small item compared to the gain in safety.
It may be asked why the problem is not solved by placing a mortgage upon the mill and thus borrowing on better terms than through the issue of preferred shares. The answer is that, in the textile industry it is a well-recognized principle that mill property should not be mortgaged. Cotton mills borrow from the banks so heavily that a banker would look with much disfavor on any permanent loan that would outrank his claim.