«Volume Title: Conference on Research in Business Finance Volume Author/Editor: Universities-National Bureau Volume Publisher: NBER Volume ISBN: ...»
4) aggregative studies of financial behavior through time; 5) studies of types of financial contracts made by business enterprises and their uses, and 6) historical studies of firms and industries.
Studies of the Formulation of Financial Plans
Most of the literature on the formulation of financial plans for businesses is found in textbooks on business finance.' Textbooks have not been addressed specifically to the central issue explored in this paper — factors influencing managerial decisions regarding forms of financing. Typically, forms of short-term financing are usually set forth in sections dealing with "working capital" and forms of long-term financing are presented separately in connection with "fixed capital." The impression is conveyed to the reader that short-term funds are appropriately used to finance current assets, and that there is little or no substitutability between long-term and short-term funds. Writers often hold that permanent working capital — the minimum amount of current assets employed by the business at all 'Among general textbooks on business finance, that of N. S. Buchanan, The Economics of Corporate Enterprise (New York: Henry Holt, 1940) is the most analytical. A. S. Dewing, Financial Policy of Corporations (New York: Ronald Press, 1941), the first edition of which appeared in 1919, remains the most comprehensive.
Other textbooks in wide usage include: H. G. Guthmann and H. E. Dougall, CorpoNew York: Prentice-Hall, 1948); W. H. Husband and J. C.
rate Dockeray, Modern Corporation Finance (Chicago: Richard D. Irwin, Inc., 1948);
F. F. Burtchett and C. M. Hicks, Corporation Finance (New York: Harper & Brothers, 1948); W. B. Taylor, Financial Policies of Business Enterprise (New York:
Appleton-Century, 1942); and H. E. Hoagland, Corporation Finance (New York:
FACTORS INFLUENCING MANAGEMENTStimes — should be financed from long-term sources of funds. They also generally accept a current ratio of 2-to-i as a useful financial standard, with some recognition of variation among industries.
The relative use of short-term and long-term funds in an enterprise may be deduced from the conventional 2-to-i current ratio. If current debt should equal no more than one-half of current assets, it would follow that the amount of long-term funds employed by the enterprise, including those furnished by owners as well as creditors, shquld be at least equal to total assets less one-half of current assets. However, it has not been established that one-half of current assets represents the proportion that is, in fact, the "permanent" proportion in year-end business balance sheets, or. that it is the proportion that should be financed by long-term funds. One must conclude that the criteria for determining the relative extent to which shortterm and long-term funds should be used in business financial plans are not explicitly stated or adequately defended in the textbooks.
Neither do textbook discussions of financial planning deal satisfactorily with the determination of the proportions of debt and equity funds within the total of the long-term liabilities of the enterprise. In the main they are characterized by treatment of a limited number of factors influencing the choice of capitalization plan, with reference in some texts to averages of aggregate data for broad industrial groupings, to empirical norms, or to "financial experience" of an unspecified nature. For industrial enterprises, Guthmann and Dougall suggest that long-term debt be limited to the lowest of the amounts established by three tests: 1) not more than one-half the amount of fixed assets; 2) not more than the amount of net working capital; and 3) not more than an amount on which the fixed charges are covered at least three times by net earnings.2 While each of these tests has some plausibility, the rationale of combining them is not clear, nor has it been demonstrated by empirical test that these criteria are superior to others. For example, if these criteria were accepted, the limits of the use by managements of long-term credit in financing would be completely inelastic with respect to the relative costs of long-term credit and equity funds. It is not conceivable that managements should be oblivious to cost factors. Moreover, the variations in the impact of cyclical fluctuations on individual firms are too large to make admissible any blanket rule applicable to all manufacturing and trading concerns.
Textbook treatments of the forms of financing public utility corporations recognize that the greater temporal stability of earning power makes it feasible for such concerns to assume a relatively greater burden of fixed 206-16, where the items are presented with some qualifications.
Op. cii., pp.
RESEARCH IN BUSINESS FINANCEcharges against net income than would be appropriate for manufacturing or trading enterprises. Therefore they suggest a larger role for long-term debt in relation to equity funds in the financial plan.3 Some texts have suggested that long-term debt may comprise as much as 60 percent of the long-term funds of a utility firm; and the Public Utility Division of the Securities and Exchange Commission appears to have adopted a standard of 50 percent bonds, 20 percent preferred stock and 30 percent common stock. The SEC standard also lacks empirical justification, but it is significant as the judgment of a body which has controlling influence over the forms of financing that may be employed by firms subject to the Public Utility Holding Company Act.
The rule-of-thumb advanced by many textbooks for the use of preferred stock in financial plans is that preferred stock should not exceed total tangible assets less total debt. An extreme application of this rule would result in a capital structure wherein the book value of common stock was equal only to the values of intangible assets carried on the balance sheet, such as patents, good will, or organization expense. Why business managements should prefer to use preferred stock forms of financing to this extent is not explained. An implication of the rule is that there is free substitutability between preferred stock and long-term debt, although the rule does not provide guidance for establishing the appropriate proportions between the two categories of liabilities.
The proper ratio of common stock to total assets is not satisfactorily discussed by the textbooks, although the relation of common stock equity to the total capitalization of the firm has usually been given a thorough treatment. To the extent that the proportions of all other types of claims on business assets have been established by some standards such as those cited,previously, the role of common stock becomes that of a residual factor in the schedule of liabilities. But since the standards used for other forms of financing are highly questionable, the determination of managerial policy for common stock financing is also unsatisfactory.
Although the role of internal financing is dealt with in some detail in textbook discussions of depreciation and dividend policy, a systematic and complete analysis of factors determining the relative uses of internal versus Burtchett's elaboration of this principle into a table indicating that the maximum percentages of financing by mortgage bonds, debenture bonds, preferred stock and common stock should vary with the degree of risk of the firm is a notable formulation. The degree of risk of a firm is measured by its average net revenue fluctuations defined as "the average percentage by which the net revenues of one year would deviate from the net revenues of the year on either side of it, when computed over a period of not less than ten years." The concept is reproduced in Burtchett and Hicks, op. cit., pp. 260-6 1.
FACTORS INFLUENCING MANAGEMENTSexternal financing is not provided. For example, the cost of funds provided internally by retention of profits is not measured. The question is rarely raised whether management is justified in using internal sources of funds to finance additional investment under circumstances where the cost of external funds would make such investment inadvisable.
In dealing with dividend policy, Buchanan has advanced the interesting hypothesis that marginal returns estimated from investment by retained earnings should be equated to returns available on capital invested outside the enterprise, but his analysis ignores such factors as the risk position of the firm, the effect upon management control, and other nonpecuniary factors influencing such decisions.4 No textbook on business finance appears to have been addressed to an evaluation of the full range of factors influencing managerial decisions on forms of financing. Sections of texts contain discussions of financial policy formation that bear upon the central question raised in this paper;
but while useful beginnings have been made, we are far from possessing knowledge that would enable us to specify the proper financial plan for a particular business enterprise, on a basis of which a decision as to the form of financing could be made by management. Further progress appears to depend upon the utilization of a more adequate framework for analysis.
Studies of Financial Standards Whereas financial plans have generally been treated from the viewpoint of the business manager demanding funds and seeking to formulate appropriate financial policies for the enterprise, the viewpoint of suppliers of long-term funds is reflected in writings on principles and practices of investment,5 while that of suppliers of short-term funds is generally conveyed in writings on commercial credit and on the operations of lenders of short-term funds.° These viewpoints are to a considerable extent con-.
'Buchanan, op. cit., pp. 233-41.
Widely known investment texts include: G. W. Dowrie and D. R. Fuller, Investnents (New York: Wiley & Sons, 1941); R. E. Badger and H. G. Guthmann, Investment Principles and Practices (New York: Prentice-Hall, 1936); B. Graham and D. L. Dodd, Security Analysis (New York: McGraw-Hill, 3rd ed., 1951); and
0. H. Evans, Jr., and G. E. Barnett, Principles of Investment (New York: Houghton Mifihin, 1940).
The developing literature in this area includes: T. N. Beckman and R. Bartels, o Credits and Collections (New York: McGraw-Hill, 1949); W. J. Shultz, Credit and Collection Management (New York: Prentice-HaIl, 1947); W. H. Irons, Commercial Credit and Collection Practice (New York: Ronald Press, 1942); and R. Foulke and H. V. Prochnow, Practical Bank Credit (New York: Prentice-Hall, 1939).
RESEARCH IN BUSINESS FINANCE
Standards of this type, along with prescriptions for minimum coverage of fixed charges by net earnings and other financial ratios, undoubtedly influence the form of financing selected by business managers.7 However, the reasoning behind legislative enactments of standards of these types is difficult to reconstruct. Presumably such factors as group norms and "financial experience" have been guiding influences, though the textbooks do not so specify.
Financial standards utilized in g?anting short-term credit are distinguished from those in predominate use by suppliers of long-term funds in two respects. First, less rigid formulas are followed, with greater reliance upon comparative financial ratio analysis. Second, a wider range of relationships is explicitly considered. The latter is a desirable emphasis. The implications of the former call for additional comment.
The basic principle of comparative financial ratio analysis is to compare the ratios for an individual firm with the median of ratios for many firms in a closely-related line of business activity. The most widely used ratios are those calculated and published periodically by Dun & Bradstreet, Inc. and by the Robert Morris Associates. The use of such ratios inevitably acts as a centripetal force upon the structure of liability and This hypothesis is confirmed by such comments as the following, received by the writers in response to a questionnaire sent to recent issuers of bonds, preferred stock or common stock: "In order to do its financing on the most favorable terms, it is considered desirable that the Company meet the investment standards as to capital structure ratios established by institutional investors, such as insurance companies, banks and other fiduciaries, the ideal ratios for a top-grade utility being 45% bonds, 25% preferred stock and 30% common stock."
FACTORS INFLUENCING MANAGEMENTSownership claims of a firm, and thereby influences managerial choices of forms of financing.
However, to observe that heavy reliance on the use of comparative financial ratio analysis by suppliers of credit will influence the forms of financing selected by business management leaves unansWered still more basic questions. The fundamental problem is threefold: to identify and quantify the factors whose effect on firms in a particular line of business activity results in some central pattern of financial relationships; to determine whether deviations from the central tendency are typically valid mdications of less-than-optimum performance; and finally, to formulate a basic explanation of observed differences in the characteristic financial patterns of businesses in different industries and lines of activity.
Aggregative Studies of Financial Structure