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«Volume Title: Conference on Research in Business Finance Volume Author/Editor: Universities-National Bureau Volume Publisher: NBER Volume ISBN: ...»

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6) Stage of life-cycle of the firm (Whether history of the firm, age of owners and managers, and other factors, indicate the firm is in a phase of growth, maturity, or decline)

7) Reputation of management (Character, experience, record of policy-making officers of the firm)

8) Composition of the firm's assets (Amount, stability, modernity, and marketability of the assets held by the firm, which affect their value as collateral

9) Collateral security available (Amount and types of negotiable securities held by the firm; availability of guarantees of obligations by officers or directors of the firm)


10) Length of the production period (Time elapsing between decision to produce and appearance of product on market, which affects the amount of risk carried on account of market fluctuations in the interim)

11) Seasonality of operations (Amplitude of fluctuations inoperations within each year, which affect amount of risk car.ried on account of market fluctuations on seasonal inventory holdings)

12) Amplitude of cyclical fluctuation (Relative amplitude of cyclical fluctuations in sales, profits and cash "throw-off" ability of the firm, and therefore in the risk position of the firm with respect to fixed commitments)

13) Record of meeting obligations (Historical record of the firm in meeting obligations when due; absence of evidence raising suspicion of fraud or evasion)

14) Vulnerability to adverse legislation (Probability that legislation or public regulation may reduce prices, raise costs, require undesired investment, or otherwise reduce the profit rate)

15) Vulnerability to labor union action (Probability that labor organizations may adversely affect profitability by raising wage rates, reducing hours of work, increasing pension provisions, medical and sickness benefits; etc.)

16) Vulnerability to competition (Degree of exposure of firm to more intense competition from new entrants into industry, new technologies, new products: extent to which profitability depends upon patents or "sheltered" positions of transient significance)

B) Financial Standards

1) The current ratio: current assets/current liabilities (The accepted measure of short-term solvency)

2) The "acid test" ratio: cash, marketable securities and receivables/current liabilities (A measure of immediate solvency)

3) The inventory turnover ratio: sales/inventory (Measures the effectiveness of purchasing and selling operations)

4) The average collection period: accounts receivable/daily sales (Measures the effectiveness of trade credit extension and collection policies and procedures)

5) Turnover of fixed assets ratio: sales/fixed assets (Measures the effectiveness of use of real estate, buildings, machinery and equipment)

6) The debt-equity ratio: total debt/net worth (Measures the extent of owners' commitments to an enterprise, and the extent of coverage of creditors' claims against it)

7) Coverage of fixed charges: net earnings before fixed charges/interest and rental commitments (Measures the capacity of the enterprise to support fixed annual commitments, and the protection afforded holders of its obligations)


8) Operating ratio: operating sales (Measures the physical operating efficiency of the enterprise in producing its products or services)

9) Net profit margin: net profits/sales (Indicates the uature of management policies, and measures over-all management performance)

10) Profitability of equity investment ratio: net profits/net worth (Measures the profitability of historical ownership investment in the enterprise)

11) Profitability of total investment: net profits/total assets (Measures the yield of assets committed to the enterprise, and approximates the "efficiency of capital")

12) Cash throw-off ability: annual net profits plus depreciation allowances (Measures the period of time required to discharge indebtedness — the "payout" period) Comments on the Classification A number of comments should be made on the classification, and certain of its implications pointed out, in order to indicate its utility as well as its limitations as an analytical device.

a) It is emphasized that the classification should, at this stage, be viewed as a series of hypotheses requiring extensive testing by empirical research.

b) The factors that influence managerial decisions directly have been grouped in five categories, referring respectively to considerations of cost, quality of funds, inherent risk, evaluation of risk, and managerial powers of control. There is some overlapping of categories as well as some overlapping of the factors within each category. For example, restrictions upon the use of funds contained in a financing contract is a factor which may affect the exposure of the firm to risk of insolvency by foreclosing alternative uses of the funds which would be more desirable in the light of changing events. It may therefore be viewed partly as a factor of inherent risk, although its more important aspect appears to be curtailment of managerial powers of control of the enterprise. In cases where a particular factor bears in more than one direction upon problems of choice, the intent has been to assign it to the category of its primary impact.

c.) Such factors as the volume of personal and business savings, the composition of savings, the level of business investment, the fiscal position of the federal government do not appear in the classification. That is because they are presumably reflected in the cost (price) of funds availOperating expenses" are defined to include only production expenses, and to exclude depreciation allowances, selling, general and administrative expenses, and taxes.


able to businesses in various forms, which does appear in the classification.

It is unnecessary in the present context to analyze the price-making forces that determine "pure" interest rates or risk-premium rates.

d) One may inquire whether or not the particular use to which a firm proposes to put the funds it is seeking is a determinant of the form in which the funds are obtained. This raises the question of the extent to which managements seek "special-purpose" financing instead of "general" financing. The hypothesis implied by the classification — which is supported by some preliminary research — is that managements ordinarily approach financing questions in terms of amounts of funds required rather than in terms of acquisition of specific assets. The working capital of the enterprise is usually regarded by managers as a pool of resources available for whatever purposes appear to be most urgent or profitable. II this be true, then the type of asset to be acquired by additional funds is not properly to be regarded as a factor influencing the managerial choice of financing forms. Instead, it influences.the forms of financing made available by suppliers of funds, by altering the composition of the firm's assets available to secure the repayment of loans. This factor influences managements indirectly, and it therefore appears in Group II.

e) Finally, some readers may accept the classification as a logical theoretical construct, but may question its usefulness on the ground that business executives do not make decisions logically. Now, in the face of the uncertainty present in a dynamic economy, business decisions never can be exercises in pure logic. Impulse, intuition, hunch and judgment inevitably play a role. The classification merely assumes rational behavior by business managers — not strictly logical behavior. It assumes that managers normally proceed as far as possible to collect, classify, analyze and draw deductions from the data pertinent to a Use of such a classification as is proposed should extend the range of rationality, by revealing all of the pertinent variables and their interrelationships. To deny rationality as a premise of business behavior would obviously be tantamount to denying the utility of making business behavior the object of scientific study!

Relative Weighting of Direct and Indirect Factors

–  –  –

of choices open to its management may be severely restricted by suppliers of funds. In a real sense, the decision as to the form its financing will take lies mainly in their hands. The firm is obliged to accept the terms dictated by the market, in the light of its characteristics and the accepted financial standards applied to it by suppliers.

To consider the opposite extreme, one may conceive of a large, established business, which is the dominant firm in a growing industry, managed by officers of high reputation, possessed of a variety of collateral security, immune to cyclical fluctuations, protected from rigorous competition by possession of patents, and relatively invulnerable to labor union activity and adverse legislation. In this case, the range of choice open to its management as to forms of financing may be practically unlimited. The principal significant factors that govern the financing decision are those of its management, listed in Group I.

These extreme hypothetical cases make clear the distinction between what decisions management would make, if the range of choice were unlimited, and what decisions management does make, within the particular circumstances in which it operates. This distinction points to the need for interpreting the structure of business balance sheets with great care. For the composite of liabilities may often indicate merely what combination of forms of financing.were in the past considered to be the best available to the business, rather than express the unfettered choices of its management. Therefore, a focal point of research into factors influencing managerial decisions regarding forms of financing should be the determination of the degree of freedom open to managements of firms possessing different sets of characteristics, given the prevailing financial standards in use.

Relative Weighting of Direct Factors

Let us assume that a firm possesses such attributes of size, age, profitability, etc. that the range of forms of, financing open to its management is unlimited for all practical purposes. In making a financing decision what weights does its management assign to each of the direct factors in Group I? The problems posed by this question derive from the fact that many of the influential factors are either difficult to measure or are inherently unmeasurable in pecuniary terms. If management is considering several alternative forms of financing, it is possible to express in dollars and cents the weight of each of the factors in the "cost" category. But factors in the other categories cannot readily be expressed in monetary units.

For example, let us assume that alternative forms of financing under consideration are: first, public sale of shares of common stock aggregating a substantial percentage addition to the number of shares already


outstanding; and, second, negotiation of a long-term loan secured by a mortgage of the firm's principal real estate holdings. Assuming that the "cost" per dollar of equity funds is 8 percent per annum and of mortgage credit is 4 percent per annum — "cost" being taken to represent the summation of factors in category A — how may management determine whether the differential of 4 percent in favor of the mortgage loan is, or is not, offset by a worsening of the risk position of the firm, or by restrictions imposed by the loan contract upon the use of mortgage funds or upon the range of management powers?

If a firm in these circumstances does issue common stock, the least that may be inferred from its behavior is that other factors jointly outweighed the cost disadvantage, in the judgment of its management, and that their combined weight may be evaluated at more than 4 percent per annum. The frequency with which business concerns in strong financial positions utilize equity financing, even when the relative cost disadvantages are greater than those assumed in this example, suggests that considerable weight is typically assigned to these other factors.


The probability that numerous influences bear upon decisions regarding forms of financing business, and the qualitative nature of many of the variables, present difficult problems of research methodology. How may one obtain the data required to test the validity of such a framework as the classification of factors presented above? Further, how may one evaluate the weights of the different factors and factor categories? The econometrician may be inclined to throw up his hands at the prospect of utilizing such a frame of analysis and conclude that it does not formulate the problem in operational terms. If so, he should concede that this may reflect the inherent complexity of the problem rather than defects in its formulation. Econometric techniques may have limited applicability, at least in the initial stages of inquiry.

The research approach that appears to hold most promise in the initial stages is microscopic examination of the financial decisions of each of a large number of firms having various economic characteristics, internal organizations, and management personnel, and operating under various sets of external conditions. The systematic accumulation of detailed knowledge about financing decisions by a large number of firms, and about the related characteristics of the firm and of its management, may make it possible to i.nduce valid generalizations about the determinants of forms of financing.


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