IX The Bank Borrower's Statement: Liabilities

CHAPTER IX THE BANK BORROWER'S STATEMENT: LIABILITIES Liabilities have already been classified and we may pass at once to their analysis and interpretation, following the order of the liability items of the balance sheet given near the beginning of the previous chapter. Bills Payable for Merchandise This item should normally be small; otherwise it would indicate failure to take discounts. Such failure might be traceable to carelessness, overtrading or backward collections,—in any event an unfavorable indication. In certain trades like the lumber, building trades, some branches of the tobacco business, etc., it is customary for the buyer to give notes in settlement of accounts. Unless it is the custom of the trade to settle in this way, bills payable, if large in amount, are an almost certain sign that the concern is "skating on thin ice." Bills Payable to Own Batiks It is a distinctly unfavorable sign if a firm borrowing heavily from a bank allows its bills to run to maturity or past maturity. Cautious bankers make trade investigations and revise their credit files every six months or every year; and if they learn, as a result of 189 190 BANK CREDIT inquiries, that their borrowers are not taking advantage of the best trade discounts, the matter is brought to the attention of borrowers at once. There are times of course when abnormal business conditions prevent the banker from being exact in enforcing this rule.

Usually its enforcement is prompted by good banking and business logic.1 It is advisable for the banker to know the maximum amount borrowed from all sources during the previous fiscal year because most concerns close their books and make up annual statements between seasons when their business is employing a minimum of borrowed funds, or none at all. Between the dates when liabilities are at a maximum and at a minimum, the proportion of quick assets to current liabilities changes markedly. Bills Payable for Paper Sold Many cases have occurred in recent years, notably a decade ago, where borrowers discounted their paper through note brokerage houses and deliberately omitted from their statements an appreciable part of such liability. This deceptive practice has been checked, chiefly, by more painstaking work on the part of bank examiners. Clearing house bank examinations have been particularly effective in checking this practice.

Although the clearing house examiner does not come in touch with paper held by outside banks, the borrower can never tell when the brokerage house or possibly * Joseph B. Martindale, The Business of a Commercial Bank and How to Safeguard the Investment of Its Funds, Proceedings, ThirtySeventh Annual Convention, American Bankers' Association, 1911, pp. 702,703.

THE BANK BORROWER'S STATEMENT 191 country bank may resell paper to one of the banks over which the clearing house examiner has supervision. There is at least a moral effect. Open Accounts Bankers should ascertain how the amount of accounts payable is ascertained. When this item is small it may be explained by the bookkeeping practice of keeping no record of the accounts payable until the accounts are paid. The item, under those circumstances is placed on the statement at an estimated amount, which may not fully represent this class of indebtedness at the statement date. Accounts payable may also be reduced in the statement as a result of the bookkeeper placing no bills upon the books until they have been audited and approved.1 It is not an uncommon practice to offset accounts payable by accounts receivable. When a statement is made showing accounts payable net, after deducting certain of the receivables there has been a misrepresentation. A liability almost invariably represents one hundred cents on the dollar, but an asset represents only what can be realized on it. Any offset of liabilities against assets is misleading unless that offset is clearly shown in the statement. In the same category should be placed such accounts as represent, for example, investment in foreign branches. The statement may reveal only the net investment, whereas to be of positive value both the assets and liabilities should be given.2 This practice, while apparently not 1 Frederick H. Hurdman, op. cit., p. 476.

•Cƒ. ¾*,rit., p. 471.

192 BANK CREDIT changing the net worth of a concern does give its statement an improved appearance. Many borrowers believe, with some reason, that they have presented a stronger statement when they show assets of, say, $150,000 with nominal liabilities than if they showed assets of $200,000 and liabilities of $50,000. Chattel Mortgages The existence of a chattel mortgage is so evidently an unfavorable sign as scarcely to deserve emphasis. "Indebtedness for back rent or a chattel mortgage on fixtures or horses and wagons is a sure sign of financial weakness."1 Bonded Debt and Interest Thereon With reference to bonded debt and interest thereon the banker should know, among other things, the redemption date and the amount of interest accrued. The early maturity of a mortgage or mortgage bonds should not escape attention, especially if the prospect of renewal or refunding is unfavorable. If the redemption date of the bonds is near at hand and provision for their refunding doubtful the banker may feel justified in regarding the principal as a current liability. Accrued interest, when it amounts to a large sum, is obviously a clear sign of weakness. Sinking fund provisions which have not been lived up to represent unquestionable impairment of strength.

1 Herman Flatau, Financial Statements, Their Form and Analysis, in Mercantile Credits, A Series of Practical Lectures delivered before the Young Men's Christian Association of Los Angeles, California, 1914, p. 78.

THE BANK BORROWER'S STATEMENT 193 Whether a borrowing concern has mortgage bonds outstanding or has borrowed on the simple security of real estate pledged by mortgage, the bank credit man usually scrutinizes the indenture in order to ascertain whether the instrument covers the land and buildings only or machinery, stock of goods, and other chattels, also. He is never pleased to discover that the mortgage overlaps and includes such free assets as equipment, or merchandise and cash. Whenever such a mortgage exists the liquidation claims of the lending bank, like those of other general creditors, are weakened. A thin equity should put the credit man on guard against the possibility of an overlapping indenture. Deposits of Money with Us This item is a very important one. Deposits of this nature are usually made by the families of members of the firm or by employees,—in either case interest is almost certainly paid upon the amount deposited.

Whatever representations the bank borrower makes as to the likelihood of such advances never being withdrawn, the conservative banker will commonly regard such an item, if large, as pregnant with uncomfortable possibilities, inasmuch as these deposits are advanced by persons who would be in a position to learn of impending disaster before any of the other creditors and in time to secure the necessary preference for their own protection. Here is a case in point. A firm failed, paying fifty cents on the dollar, it being more than suspected that a number of women,—members of the family,—who had advanced money, had been just 194 BANK CREDIT previously to the collapse of the concern paid off or secured at the expense of the other creditors.1 The contention of many business men that the appearance of large deposit accounts in the statement indicates additional security, as those closely interested are shown to be willing to entrust their money to the concern, loses its force when we remember that those closely associated with the managers or principals may be in a position to scent danger earlier than the banker and other creditors and, having secured the repayment of their own advances, place the burden of the enterprise, weakened by the withdrawal of the "deposits," on the shoulders of the bankers and general creditors.

Other Liabilities Other liabilities not mentioned in the list on page 163 may be very varied. Accrued, deferred and contingent liabilities alone seem to call for comment. Some bankers treat contingent liabilities, which usually arise from endorsed and discounted notes receivable or endorsements for accommodation, as a part of the borrower's current liabilities. To do so where such contingent liabilities are heavy changes the ratio of quick assets to current liabilities very unfavorably to the borrower. Let us suppose a borrower presents a statement showing Quick Assets $200,000 Current Liabilities $ 50,000 Permanent Assets 200,000 Permanent Liabilities.. 350,000 $400,000 $400,000 'William Post, Analysis of Borrowers' Statements, Journal of Accountancy, Vol. I, No. 3, January, 1906, p. 189.

THE BANK BORROWER'S STATEMENT 195 The borrower would have, according to this statement, a ratio of quick assets to current liabilities equal to 4:1. If a bank loaned the maker of the statement $50,000, the ratio of quick assets to current liabilities would be 2½ to 1, a ratio that is commonly regarded as safe. If contingent liabilities amounting to $150,000 arising from customers' notes discounted are discovered, however, the face of the statement becomes changed decidedly for the worse; if the contingent liabilities are looked upon as an addition to the current liabilities, the ratio of quick assets to current liabilities would become 1 to 1. Some bankers are inclined to treat contingent liabilities as we have done here, although it is an extremely conservative practice. Accrued liabilities, corresponding to accrued assets, are exemplified by wages payable, taxes payable, rent payable, interest payable. Deferred liabilities differ from accrued in being paid finally, not in cash, but in services or commodities,—in product. Milk tickets outstanding in the hands of customers and for which payment had been received by a dairy company would stand for a deferred liability of the company. Prepayments in connection with services or products give rise to deferred liability items on the books of the concern receiving the payment. Deferred liabilities are distinctive but generally of less importance to the lending banker than accrued liabilities.

The absence of accrued liabilities in the statement may usually be taken as evidence that the accounts of the concern have not been accurately kept. Where accruals for taxes, interest, rent and other items appear, an effort, at least, may have been made to ascertain 196 BANK CREDIT exactly the operating results of the period under review and the condition of the affairs of the concern at the date of statement. The discovery only after investigation that taxes or interest in large amount, but not mentioned in the statement, are soon to fall due is not calculated to inspire confidence in the banker as to the security of the loan sought. Although it is frequently asserted that no liability should be set up for such items as interest, taxes, and rent until they fall due, the conservative and correct practice is to make these items accrue regularly so that the earnings and financial condition may be stated accurately.

Capital and Surplus, Proprietorship Interest or Net Worth A business corporation as well as a bank ought to have a capital sufficient to support its volume of business. In national and most state banking corporations capital is more highly protective to depositors and other creditors than is surplus because of the double liability of stockholders in those institutions. In business corporations, where limited liability of shareholders generally prevails, surplus, as long as it exists, affords protection in the same degree as does capital. It is an interesting commentary on the question of the existence of actual surplus in American corporations that of those whose securities are listed on our foremost stock exchange and selüng below par over long periods of time a great majority show book surpluses. It must be evident that surplus can be easily manipulated simply by changing the valuation of items in the balance sheet.

THE BANK BORROWER'S STATEMENT 197 When the borrowing concern is an individual or a partnership, capital and surplus combined take the form of net worth. Relatively small net worth maybe fully offset occasionally by other and outside resources of the borrower. The reader will of course have in mind the fact that limited liability does not commonly pertain to the partnership. But whether the application for a loan comes from a corporation or some other form of business organization the lending banker, if conservative, must insist on a satisfactorily large capital investment and protection. Lack of capital entails constant strain on the borrower and renders him a prey to adverse business, credit, or collection conditions. Ratio of Quick Assets to Current Liabilities Credit men are even more concerned about the ratio of quick assets to current liabilities than they are about the net worth or capital and surplus of the applicant for a loan. Net worth may be very great but in the form of slow assets. The banker fails to safeguard the interests of his depositors and shareholders unless he uniformly insists on a safe ratio of quick assets to current liabilities. What constitutes a safe ratio varies from case to case, but hovers around 2 to 1, after the desired loan has been included. Allowance for a shrinkage of 50 per cent is generally regarded as sufficient and when the moral risk is exceptionally good, earnings highly satisfactory or slow assets relatively large, a ratio of very appreciably less than 2 to 1 may be acceptable. Departure from the 2 to 1 rule is very common.

198 BANK CREDIT Relation of Net Worth to Credit Worth What is the proper and safe relation between net worth, the proprietorship interest, or capital and surplus on the one hand and credit worth on the other? It is maintained in banking circles that unsecured loans should not be made greatly to exceed one third of the net worth, where the banker is well acquainted with the business, ability, and morals of the borrower.1 Nevertheless the ratio varies widely from banker to banker and from borrower to borrower. Even the bank balance maintained by the applicant for a loan will be one of the determining factors. No hard and fast rule can be laid down. 1 Robert A. Parker, Practical Credit, Bulletin of American Institute of Bank Clerks, Vol. VI, p. 354.