X The Bank Borrower's Statement: The Income Account

CHAPTER X THE BANK BORROWER'S STATEMENT: THE INCOME ACCOUNT Although the asset and liability statement is sometimes submitted with an application for credit, without a statement of income and expenses, the latter is of indispensable value to the credit man in reaching an intelligent decision. The one minors a condition on a given date; the other shows how that condition was achieved, and indicates the trend of the business, whether favorable or unfavorable. Deficiencies in the balance sheet may be outweighed by substantial and steadily growing profits reflected in the income account. A thriving business with growing profits is a more satisfactory credit, even if the ratio of quick assets to current liabilities is comparatively low, than a concern showing a liberal margin of assets but with a dwindling profit and loss account. One is growing constantly stronger, the other less and less desirable as a risk. One inspires confidence, the other apprehension.

Many applicants for loans who submit balance sheets are still reluctant to include a statement of profit and loss account, and some compromise by giving merely the final net profit (or loss). A complete profit and loss statement ought to be obtained and carefully scrutinized because of the light it may throw upon the items in the balance sheet. The banker 199 200 BANK CREDIT must make sure that the credits do not represent sales of assets. Let him also compare the debts with previous statements in order to check the omission or reduction of charges like depreciation, a practice sometimes resorted to in order to make a creditable showing of earnings in poor years. "The capitalization of repairs and maintenance pads the profits as well as the permanent assets accounts." * A condensed profit and loss statement or income account of the following character contains the main items of expense and income: Expense Gost of material or merchandise consumed $ Actual expense of conducting business: Including rent, taxes, insurance, etc Salaries paid to officers Interest on borrowed money and bonds Bad debts charged off Depreciation charged off Net profits Total $ Income Net sales $ From investments From discounts on purchases From other sources Total $ 1 Clay Herrick, Borrowers' Statements and the Rulings of the Federal Reserve Board, Proceedings, Twenty-Fifth Annual Convention, Ohio Bankers' Association, 1915, pp. 51, 52.

THE BANK BORROWER'S STATEMENT 201 Items among the expenses that call especially for comment are expenses of conducting the business, salaries paid officers, and depreciation. The others are self-explanatory or scarcely call for comment. The actual expense of conducting the business is an index of capacity and is closely watched by the careful credit man. Large banks with well equipped credit departments, having several customers engaged in the same line of trade or manufacture, are able to compare this item advantageously to both the bank and the borrowing concerns whose expenses are relatively high. The cost system of the borrower should receive very special attention, "for it is in the cost system that money is most generally made or lost."1 Without a well developed cost system a borrower cannot have a thorough grasp of his business. Insurance Insurance is an item that does not escape the banker's attention. The banker looks Upon failure to insure adequately with great disfavor for two reasons: such failure jeopardizes the safety of the credit extended and also indicates a lack of business capacity on the part of the borrower.

Salaries and Cash Withdrawals Salaries paid to officers deserve scrutiny. If salaries paid represent amounts withdrawn from a business by 1 Thomas J. Kavanaugh, EssentiaL· in the Granting of Bank Credits, Principles and Methods which Should be Observed, Trust Companies, Vol. XXIII, No. 2, August, 1916, p. 120.

202 BANK CREDIT its members for living expenses, such withdrawals may throw strong light on the moral risk. High living has a doubly unfavorable action. There is an actual and perhaps serious danger to the stability of the business occasioned by the withdrawal of funds to meet the expenses of an extravagant mode of life, and in addition high and reckless living may invite heavy costs in defending suits or in satisfying court judgments or decrees. Depredation Depreciation is a cloak that may conceal the source of "unearned" profits. The smaller the amount allowed for depreciation the greater the book profits. Accordingly, the banker needs to compare depreciation year after year in order to assure himself that adequate and reasonably uniform provision is made for the wear and tear and obsolescence of plant and equipment. If the plant is overworked a heavier charge should be found in this item.1 Where liberal amounts for depreciation are charged off over long periods and when betterments and extensions are charged to operating account rather than to capital account the earning power of the concern tends 1 It is easy for the bookkeeper to create "book" profits. If the business of the borrower has been below normal in results a portion of what should be placed in operating accounts, such as repairs or renewals, may be charged to a building or fixture account. The method or basis of inventory may be changed, the inventory item and net worth inflated. The amount set aside for bad debts may be reduced. These and other ways of manipulating the statement may be employed to demonstrate that a thriving state of affairs exists when the opposite condition really obtains.

THE BANK BORROWER'S STATEMENT 203 to grow in relation to its capitalization. Many New England cotton mills have followed this policy to such an extent that the value of their output is frequently several times their capitalization. As a result they have distinctly enhanced their credit position. New England cotton mill paper has long sold at comparatively low rates and has been regarded highly by the banks. The mills have been able, on account of their easy financial condition, to take advantage of the market from time to time either in buying raw material or in disposing of the manufactured product. The location of the mills, also, has been partly responsible for the low rates at which money has been placed at their disposal. The New England mills are geographically a part of the great money centers, a circumstance that promotes a close personal acquaintance between the mill and the banker, enabling the banker, moreover, to investigate more easily the condition of the mills as prospective borrowers.1 Packing companies and other companies such as shoe, clothing, and other manufacturers permanently located are governed in their depreciation charges by the appreciation or depreciation in real estate, the life and cost of up-keep of their buildings, machinery, etc.; but there are other companies such as those manufacturing timber products that are further controlled by the supply of raw material in their territory and it usually becomes necessary for such companies to write off their entire plants in time to cost of production as it »Daniel G. Wing, New England and South Carolina, Proceedings, Fifth Annual Convention, South Carolina Bankers' Association, 1905, pp. 48, 49.

204 BANK CREDIT does not pay to move them when the supply becomes exhausted. With such companies it is usually calculated that their plants should not exceed one dollar per thousand feet of timber owned by them. However, in some cases where large supply of custom timber is available, such a rule should not rigidly apply. In shoe companies and printing companies, etc., depreciation of machinery through wear and tear and obsolescence is severe, and it should be ascertained whether or not write-offs are commensurate. Depreciation ties inventory for place of first importance in a financial statement. They are the two magnitudes the exact status of which it is hardest to ascertain and many borrowers fool both themselves and their banks in both items.1 Sales Few items in the income account are more significant than that of sales. The volume of sales divided by the inventory, in the case of a mercantile concern gives the rate of turnover and turnover in any given line of trade is an excellent index of the quality and character of the inventory itself. We say any given business because the turnover varies decidedly from business to business. A staple business handling stock easily replenished like a wholesale grocery would have to carry no more than two or three weeks' sales. A retailer of furs on the other hand would show, if mak1 Thomas J. Kavanaugh, Essentials in the Granting of Bank Credits, Trust Companies, Vol. XXIII, No. 2, August, 1916, pp. 119, 120.

THE BANK BORROWER'S STATEMENT 205 ing his statement in October, an inventory almost equal to his year's business.1 Again, a comparison of sales and accounts receivable enables the credit man to determine the age of the latter. Where merchandise is small and accounts receivable large there is an indication of slow collections, of stale accounts. In such a case the credit man will likely insist on a high ratio of quick assets to current liabilities. Net Profits In comparing the net profits of a concern from year to year or period to period, the banker expects to see improvement but not necessarily improvement every year. In fact it inspires confidence in the truthfulness of the showing if a year or two are found when conditions precluded the probability of profit in the given line and the statement reflects those conditions. An unbroken symmetrical gain should put the banker on his guard. Too much money made in a single year may in some instances suggest speculation.2 Collateral information relative to earnings is always illuminating. Mr. Clay Herrick3 cites the case of a company that showed a statement of such character that on it as a single basis any banker would have been tempted to advance funds freely. Assets were large, 1F. B. Snyder, Credits, Money and Commerce, February 17,1917.

2 F. W. Crane, Commercial Paper Bought from Brokers, Thirtys¡xth .Annual Convention, Illinois Bankers' Association, 1916, p. 138. •Clay Herrick, Borrowers' Statements and Oie Ridings of the Federal Reserve Board, Proceedings, Twenty-fifth Annual Convention, Ohio Bankers' Association, 1915, p. 52.

206 BANK CREDIT net worth was large. Earnings for a long period had been strikingly good. Investigation, however, developed the fact that a lucrative contract which was the basis of the concern's large earnings and then flourishing condition was about to expire without possibility of renewal. Dividends The banker is always interested in the dividends paid by a borrowing corporation. A dividend record in itself throws some light on the earning power and credit worth of the borrower—after the banker has assured himself that the dividends paid have been justifiable. On the other hand dividends create a void to fill which the banker's advances may be sought. Dividends may be much less than earnings and still be improper. If the earnings of a corporation for a given year are $100,000 and during the same period $50,000 are turned into improvements, and the concern at the end of the year pays a dividend of $100,000, the working capital has been impaired by $50,000. Fixed capital has been increased and sooner or later additional fresh working capital is almost certain to be needed, in order to keep the working or liquid capital of the concern up to its normal proportion to fixed. Unless the banker is careful he may advance funds to pay dividends or meet withdrawals by partners and it may turn out that such dividends or cash withdrawals are being invested in another or other enterprises in which the borrower has a greater and growing interest.1 1 Cƒ. Frederick H. Hurdman, op. dt., pp. 477, 478.

THE BANK BORROWER'S STATEMENT 207 The Borrower's Capacity The banker scrutinizes the borrower's statement in order to discover evidence of good or bad management, and naturally enough his attention is directed chiefly to earnings. Earnings that are known to the banker to be real and legitimate over a long period constitute a satisfying index of capacity. Where this criterion is lacking, owing to the youthfulness of the concern or to other factors, the credit expert attempts to acquaint himself with the technical side of the borrower's business. If the borrower is known to be lacking in a knowledge of the technical requirements of his business or weak hi administrative capacity the credit risk will be clouded. The cautious banker also looks well into the character of the assets of the borrower. Clean fresh and salable inventory is a favorable indication. The mismanagement that causes failure is nearly always reflected in the character of the assets of the bankrupt.1 The information that the banker gains concerning the capacity of the borrower comes in part from reading between the lines of the statement, and in part from independent investigation. The interview, where that is practicable, is also of value.

From what has been said in this chapter and the two preceding, three main facts stand out. The first is that the banker is primarily interested in the ratio of the borrower's quick assets to his current liabilities. The second is that the borrower's net worth or "capi>A. C. Foster, Bank Credits, Bulletin, American Institute of Banking, Vol. II, p. 237.

208 BANK CREDIT tal," while not of immediate interest to the banker, is nevertheless of vital interest to him inasmuch as he may be compelled to fall back upon the excess of assets, however slow they may be, over liabilities in the event of misjudgment or mishap. The third is that if statements over a considerable period show reasonable net profits, provided there has been no sudden unexplained swelling of the plant account, no abnormal increase in the merchandise account or other similarly fictitious profitmaking expedients, the presumption is highly favorable to safety.1 Whether a borrower does or does not submit a statement, the banker attempts to uncover these basic facts before making a loan. In order to do so he does not rely solely on the borrower's own written or oral statement. The modern banker supplements and verifies or disproves the contents of the borrower's own statement by an investigation the thoroughness and extent of which would frequently be a surprise to the subject investigated. Even many country banks are now building up credit files, the contents of which are in part traceable to the direct investigation efforts of the country banker himself, and in part to the liberality of his city correspondents. We shall consider in the next chapter the nature of this supplementary but essential and illuminating investigation of the borrower's credit worth. It is in place, however, before passing on, to point out the benefits of rendering a statement to both banker and borrower, and the significance of the borrower's refusal to render a statement.

lCf. H. A. Wheeler, Credit Information, The Financial Age, Vol. XXII, No. 23, November 14, 1910, p. 1164.

THE BANK BORROWER'S STATEMENT 209 Reciprocal Benefits of Bank Borrowers' Statements The interests of the banker and his borrowing customers are, or should be, very closely allied; whatever benefits the borrower benefits the banker in turn. The direct benefits to the bank of the practice of borrowers rendering statements are obvious. The indirect benefits, those derived through the improvement in the credit risk of the borrower which flows from making a statement, particularly an audited statement, are probably equally great. The benefits or advantages accruing to the borrower and indirectly to the banker as the result of rendering periodical statements may be stated categorically. 1. The very fact that such statements are to be made annually and submitted to one's banker doubtless has a tendency in many cases to cause the more ambitious men to go a little more slowly in extending their business than would otherwise be true,—a circumstance that tends to enhance the safety of the banker's interests and at the same time save the borrower from financial distress, if not failure. Careful analysis of statements is beneficial in repressing the too buoyant but honest optimism of some concerns.

2. In the furnishing of credit statements, it gives the banker a good understanding of what borrowers are doing, and makes it possible for him to give advice at times which may be helpful. Even though one may not be for the moment a borrower, we believe it well that he voluntarily supply his banker with a carefully prepared financial statement of his condition, for, added to the benefit which would probably come to 210 BANK CREDIT him as the result of a careful study of the details of his business in the preparation of the statement, is the decided advantage of the close contact and relationship thus established between the two parties. Business men are being inquired about constantly as to their financial responsibility by other men in business, and the banker is a frequent source of information. 3. In order to make a statement that is true and correct and do it readily, a borrower's accounts must be conducted so as accurately, plainly, and minutely to set forth the business done from day to day, and the possession of such a record is of great assistance to the owner or manager in discovering leaks, or troubles leading to losses. Large losses are often sustained, especially in an active business, because of the lack of knowledge on the part of the responsible head of the details of his business. A representative of a large manufacturing concern once said that "his company experienced no difficulty in competing with wellmanaged companies, who fully understood their business; the most vexatious problems being competition with those manufacturers who kept on making money until they reached bankruptcy."1 The banker or credit man may at times, in analyzing the data submitted, perform, in a measure, an auditor's service for the borrower. A business man unfamiliar with accounting and the interpretation of accounting facts may be disillusioned by his banker. Let a Detroit banker give us a concrete illustration: 1R. A. Long, Necessity for Credit Statements and the Desirability for Uniformity thereof, Proceedings, Fortysecond Annual Convention, American Bankers' Association, 1916, p. 530.

THE BANK BORROWER'S STATEMENT 211 A customer gave his report to us in January; I looked it over, compared it with his previous statement, and he appeared prosperous; but in looking it over more carefully, I discovered a greater volume of business, but a lesser volume of profit, and in going still further I found a leak apparently in his expense account. I sent for him and . . . said, "Joe, you don't seem to have done very well last year." "Yes, I did a good business, . . . twice as much as last year." I said, 'You didn't make as much money." "Yes," he said; but upon investigation we found he had been losing money, by the old bookkeeper. We finally got him straightened out, and I think he will make some money this year, and that was simply because I cautioned him. He was not paying close enough attention to his business, and the old statement he filed with us was really valuable to him and valuable to us in showing the condition of his credit.

When a borrower complies with the request of his bank for a statement it frequently gives him an interest in his affairs that he never had before. He takes pride in rendering another statement the next year, particularly if he is prospering and is the right kind of a borrower.1 Significance of Refusal to Render Statement Some firms dealing with even city banks do not make statements from fear that their actual condition would become known and be a disappointment to those who consider their position and business to be better than it actually is. On the other hand, the fear may 1W. S. Weston, The Credit Department of a Country Bank, Proceedings, Sixteenth Annual Convention, Nebraska Bankers' Association, 1912, p. 34.

212 BANK CREDIT be that their condition would be found too prosperous and invite others to enter the business and compete. In these instances there is no defined rule to be laid down as to the extension of credit. All the circumstances must be taken into consideration and the case decided on its merits. It is the testimony of an experienced New York banker that more often, when a man refuses to make a statement, it is because he dare not rather than from fear of showing too much prosperity.1 There are, however, many cases where some of the best concerns in the market have never made and never will make statements of their affairs. Some of the choicest names in the New York market whose paper the banks¯do not hesitate to buy in large amounts, or to discount liberally, are those of concerns that refuse to make even so much as a statement of the amount of capital invested. They are, nevertheless, known as very reliable and able concerns that have been in business for many years. Their names stand for integrity and honor; their methods are believed to be sound and correct.2 In general it is the safer practice for the banker to avoid the glamour of great names and great concerns that refuse to exhibit a condition of their affairs. A concern that is financially strong will almost invariably 1 Robert A. Parker, Practical Credit, Bulletin, American Institute of Bank Clerks, Vol. VI, p. 353.

2 Joseph B. Martindale, The Business of a Commercial Bank and How to Sagefuard the Investment of Its Funds, Proceedings, Thirtyseventh Annual Convention, American Bankers' Association, 1911, p. 702.

THE BANK BORROWER'S STATEMENT 213 court investigation.1 Where an applicant for a loan refuses to make a statement or give credit information the way in which the refusal is made may be a clear indication of his condition. 1 Lowrie C. Blanding, The Study of Commercial Credits, Proceedings, Eleventh Annual Meeting, Iowa Bankers' Association, 1897, p. 38.