Inability to Secure Cash for Refunding Operations
Corporations sometimes issue bonds because of the fact that a larger return is gained to the stockholders than if more stock were sold. The interest rate on bonds is generally much less than the rate of profits and even less than on short-term loans or notes. The distinction between bonds and notes is mainly that of time. The proceeds from the bonds are commonly used for permanent improvements, while the notes are issued to bridge over the changing of some form of quick assets into cash. Generally the bonds are issued during a period of easy money but they may mature when the money market is hard. If a sinking fund has been provided, all that is necessary is to convert the securities in which the funds have been invested into cash and take up the bonds. But the fact that the returns on the securities in the sinking fund are as a rule much less than can be realized by placing the money in betterments, operates against its use.
When, therefore, the bond issue becomes due in a period of financial stringency, or even during normal times if the business has not been highly successful or if its credit has been impaired, the company may be unable to liquidate its assets and pay it off. The consequence is that a foreclosure of the mortgaged property is made.
Excessive Borrowing on Short-Term Securities
A frequent cause of insolvency is excessive borrowing by means of short-term securities in the form of accounts payable, acceptances, and notes. The notes may be classified into: (1) notes discounted at some bank; (2) notes sold to the public; and (3) merchandise notes. There are three legitimate uses to which they may be put, namely: (1) to take care of a temporary lack of funds; (2) to extend further credit to customers; and (3) to increase the stock of easily marketable goods on hand. Definite provision must be made to meet the notes at maturity, which in the case of bank loans run from 30 days to six months—generally 60 to 90 days. The use made of funds obtained in this manner is a matter of importance to bankers when extending loans.
To use any one of these forms of borrowing for the purpose of financing betterments and additions is dangerous and essentially unsound. Such obligations are generally contracted during a period of prosperity and expanding business for the purpose of taking care of temporary needs. They frequently become a source of embarrassment when a period of money stringency sets in. If the borrowings are in excess of the quick assets, the policy is unsound at all times. Conservative managers make provision for meeting their notes at maturity before they issue them.
The short-term notes sold to the public usually are for longer periods than those discounted at the banks—the period ranging from one to five years. When the time is not appropriate for a bond issue and it is desirable to defer it, short-term notes are generally issued and marketed through note brokers, often throughout the country. This is an effective means of deferring a bond issue until money is easier and better terms can be obtained for the larger issue. When the bonds are sold the notes are retired with a part of the proceeds. The danger of this financial practice is that the notes may mature before the bonds can be marketed, as would probably be the case if a period of depression ensued. This would involve disaster if provision for refunding had not been made, especially as the proceeds of such notes, like the proceeds of a bond issue, are generally used for betterments and additions.
Losses in Conducting the Business
A business, through defects of management, does not always fulfill the expectation of its promoters. The price of the product may be set without regard to true costs, and losses pile up with or without the knowledge of the management. Competitive conditions may have to be met and efficiency of management be an absolute requisite if profits are to be made. An organization is of slow growth and the price paid for experience may eat up all the profits. Poor workmanship, duplication of effort, poor planning in the factory, resulting in a high unit cost—these are all factors which may bring disaster if not detected and remedied in time. The promoters may have been unusually optimistic in regard to the business that could be done, with the consequence that a plant is constructed much in excess of actual market possibilities. Losses of a serious nature then result from the poor utilization of fixed assets. “Lack of ability” is the phrase commonly used in describing this cause of insolvency. The usual symptom of the malady is a reduction in current assets and greater difficulty in obtaining credit.
Loss through Fraud, Theft, or Unavoidable Causes