# Hints About Investments/Chapter 9

For the year ending June 30, 1925, Messrs. Bass, whose balance-sheet has already been the subject of our study, published the profit and loss account on page 131, which was attached to the balance-sheet and the directors' report.
On one side we see the receipts of all kinds, less certain expenses, plus the balance brought forward from the previous year; on the other, the payments that have been made, including interim dividend on ordinary shares, and the provisions made for depreciation, etc.; and the two sides tally by the addition to the payments and provisions of the sum that is left over to be carried to the balance-sheet.
A profit and loss account thus shows us the process by which the figures of the balance-sheet are produced, by giving us, among other things, the sums deducted from the book values of property, investments and debts due;
Balance Sheet as at June 30, 1924 :
| Dr. | Dr. | Cr. | Cr. |
| To rents, rates, taxes, insurance and compensation fund | £197,387 | By sales of ale, stout, and sundry products, less manufacturing and cooperage expenses, excise duty, brewing licences, and carriage | £1,267,630 |
| To repairs and renewals of premises and plant | 98,388 | By sundry rents, interest and dividends | 259,298 |
| To depreciation of freehold and leasehold premises, licensed property and plant | 62,591 | By transfer fees | 168 |
| To salaries, travelling and agencies expenses, advertising, show cards, labels, stationery, law charges, retiring allowances, subscriptions, gifts, directors’ and auditors’ remuneration and sundries | 543,343 | By balance brought forward, June 30, 1924 | 93,429 |
| To interest | 7,058 |
| To bad debts, reserve for doubtful debts, and depreciation of investments | 81,661 |
| To interest on mortgage debenture stocks | 80,800 |
| To dividends on preference stock | 68,000 |
| To interim dividend of 3 per cent. on ordinary shares | 61,200 |
| To balance carried to balance-sheet | 420,097 |
| £1,620,525 | £1,620,525 | £1,620,525 | £1,620,525 |
​those sums are deducted out of the revenue of the company, in order to provide for depreciation of property through wear and tear and obsolescence, for decline in the prices of investments, and for default, whole or partial, on the part of debtors. The result of the process is that the figures at which the assets affected stand in the balance-sheet are reduced and so the margin between liabilities and assets, which constitutes the balance available for distribution, is reduced likewise.
This one shows the imposing total of over a million and a quarter of gross profit, from sales of the company's product, less the cost of producing and conveying it and the charges made by the Inland Revenue for excise duty and brewing licences. A curious inquirer would have liked to see a little more—to have been told what was the sum of the gross sales and how much was taken off under each of the headings into which the expenses were divided. The answer of the Directors would no doubt be that they cannot be expected to give away information which might be valuable to their rivals. This answer must be accepted under present conditions. Perhaps the day will come when the growing curiosity of Labour concerning the nature and extent of profit, and the emphasis now laid on profit sharing ​schemes as a solution for industrial unrest, will oblige all employers to publish really full and informing accounts, observing definite and accepted rules for the treatment of depreciation. But that is another story.
Rents, interest and dividends (presumably from the licensed premises and investments owned by the company) bring in £259,000 odd and with the trifle received on transfer fees (charged by the company for registering transfers of its stocks and shares from one owner to another in its books) and the carry forward from the previous year, £93,429, the total receipts to be accounted for come to £1,620,525.
Looking at the other side of the account we find that what may be called inevitable charges under the headings
(1) rents, rates, taxes, insurance and compensation fund,
(2) salaries and all the other items bunched up with them (though subscriptions and gifts may perhaps be called optional),
(3) interest (presumably to creditors) and interest on debenture stocks,
absorb in all £828,588.
What may be called optional items—those about which the opinion of the directors as to ​how much should be spent or allowed is the deciding factor—are
(1) repairs and renewals of premises and plant,
(2) depreciation of freehold and leasehold premises, licensed property and plant, and
(3) bad debts, doubtful debts and depreciation of investments.
These come to a total of £242,640.
It is in exercising their judgment on the reservation and allocation of this sum, which is enough in this case to pay nearly 12 per cent. on the company's ordinary capital, that the directors have to perform what is perhaps their most responsible duty. In their decision about it, and in parallel decisions which have to be made by all Boards of companies engaged in production, transport and commerce and in nearly all forms of finance, prudent Boards set aside sums that err on the side of over provision for depreciation of property and investments and for doubtful debts, and on the side of excessive lavishness in repairs and renewals so that the property may be always rather more than up to date.
Thereby they act in the best interests of the ​property, the business, the shareholders and themselves; but their excess of virtue lays them open to the charge of putting away hidden reserves, tucking away profits and so forth. Of shareholders, who feel aggrieved on this score, one can only say, as the unwillingly sober sinner said of his completely incapacitated comrade, "I wish I 'ad 'alf 'is complaint."
Imprudent Boards hope for a more favourable opportunity for making fuller provision; fraudulent Boards, which are happily rare, deliberately make provision that they know to be insufficient; and so the amount of the profit that is carried to the balance-sheet is increased at the expense of the efficiency of the business and of the profits of future years, and to the ultimate undoing of the shareholders, and of the directors themselves if they were merely imprudent and in the end we may hope, though it is not safe to bet on it, even if they are fraudulent.
But surely there must be a middle course—a policy that will not write off too much or too little, but will give us the truth, the whole truth, and nothing but the truth?
"'What is Truth?' quoth jesting Pilate, and paused not for an answer." Who can say what is the strictly correct amount to spend ​on repairs and renewals or to provide for depreciation of investments that have no quotation, or for the doubtfulness of doubtful debtors? If you are going to answer that companies ought not to invest in securities that have no quotation, or lend money to debtors, who are doubtful, then you are putting a drag upon enterprise, which would make business on its present scale impossible. "Wise Venturing," wrote the great Lord Halifax, "is the most commendable Part of human Prudence. It is the upper Story of Prudence, whereas perpetual caution is a kind of underground Wisdom that doth not care to see the Light."
The book values of what may be called the arguable assets are originally the sums paid for land, buildings, machinery, plant and investments and the price of goods sold to buyers who were not in a position to make immediate payment for them. A sum paid for a piece of property is something definite to put down in an account, though within five minutes after it has been paid, and before the ink on the cheque is dry, the buyer may know in his heart that he has paid too much and that he has no right to credit himself with his asset at this figure if he is really making an estimate of what he is worth. It has probably ​happened to most of us to fall in love with a house or a picture or a something and to have paid hastily the sum asked for it lest someone else should snap it up, while one is quite conscious that it would be very difficult to sell it again at anything like the same figure, unless one were fortunate enough to find an equally eager buyer.
In business such individual whims do not often exert much influence, but trade competition sometimes produces startling results, as for example when some years ago the breweries were bidding against one another for the possession of licensed premises which they wanted to acquire and confine to the sale of their own products by making them "tied houses."
If, then, original cost even in the year when the sum is paid for property is not always a figure that can be set against in a balance-sheet that aims at truth—if truth means realizable value—who shall say at what pace it ought to be written down in the years that follow or what is the figure to which it should finally be brought by the process of annual reduction? Evidently there is a great difference in this respect between one item and another. Of land, Mr. Leake says definitely that "for accounting purposes" it "should be ​stated at cost, because the capital outlay thereon does not expire as it does in the case of wasting assets"; and again on a later page "Freehold land is not a wasting asset." Here at last we have a bedrock fact on high authority; and yet a heretic might suggest that freehold land is an asset which though it may not waste, very often changes in value. To say nothing of the land owned by a mining company, which exhausts it before it has done with it, because this is evidently an exceptional case, even a factory site may have its value seriously affected by the development of improved transport facilities elsewhere, or by a dozen other influences.
Leasehold land is an item which can be definitely calculated because it is known that so much has been paid for the use of it during so many years, at the end of which it will revert to the owner. Here then the directors and auditors have a question of simple arithmetic to work on, and all that they have to do, or to see done, is the setting aside of an annual sum which will wipe out the book value of leasehold land by the date of the expiry of the lease. But even here there is nearly always a necessity for provision, to an extent which is a matter of opinion rather ​than of certainty, for possible liabilities and expenses at the termination of the lease.
Buildings are a difficult problem. At first sight it would seem that as long as they are well maintained in good working order and all necessary repairs are carried out, they are as good as new, and rather better, for the purposes of the business, because they and the business have grown used to one another and "found" themselves like the ship Dimbula in Mr. Kipling's story. But a business is not put away to mature like wine in a bottle—and even wine needs re-bottling at intervals. A business has to grow and its buildings seem to shrink like a schoolboy's clothes. At the present moment the Bank of England is rebuilding itself, and its determination, for artistic reasons, to preserve its old outside walls is probably adding considerably to the cost of the process.
As to rapidly wasting assets, such as machinery and plant, there is no doubt that they have to be written down fast because in a less or greater number of years they will be worn out; in some cases it is even possible to calculate the life of a machine with some approach to accuracy. But even then the question of obsolescence has to be considered. In some up-to-date works it is boasted that ​no machine has ever been known to wear out because it has always been superseded by a better one, and sent to the scrap-heap long before it had ceased to work efficiently.
As to unquoted investments a rough value can be arrived at from the income received from them, though there may always be room for much argument as to the basis on which this income should be capitalized; and it may often happen that a holding of shares on which no dividend at all is received may bring indirect business advantages which should rightly figure in a balance-sheet which aims at truth. But the sum at which they ought to figure is a matter which may cause very wide differences of opinion.
And when we come to doubtful debtors, hope pulls one way and fear pulls the other, and who is to decide between them? Trade possibilities and the psychology of the debtor reacting on and confusing one another make them in some ways the most difficult problem of all. Yet Mr. Leake says that "it is comparatively easy to estimate the value of book debts, or of stock-in-trade, because such assets are likely to be turned into money within a short period of time." But the mere fact that provision has to be made not only for ​doubtful debts but for definitely stated bad debts, seems to indicate that Mr. Leake's likelihood is not always a certainty.
Stock-in-trade should be capable of fairly close calculation if it be estimated on the basis of cost of materials plus cost of work put into it; but there is probably a considerable difference in the practice of one management and another in the care and caution with which these estimates are made.
Mr. Pixley, indeed, says that "The amount to be taken credit for in respect of stock is of supreme importance in many companies, as it is no exaggeration to state that it is frequently possible to double or treble the apparent profit, where the directors and manager together, or even the latter alone without the knowledge of the former, succeed in deceiving the auditor, and consequently the shareholders. The auditor cannot, of course, be held responsible for the value assigned to this stock, as it is manifestly impossible that he should, even if he were qualified, be able to take or to check the actual measurement or counting of stocks, whether of raw materials or manufactured articles, either by number, weight, or otherwise, but he must use reasonable discretion, when the valuation of the stock is handed to him in satisfying ​himself that it has been arrived at in a systematic manner. . . . In some cases it is desirable to ascertain whether much of the stock has been on hand for a long period; as it may lead the auditor to form the opinion that the price taken credit for should be reduced, either owing to depreciation in the goods themselves, or to the inability of the manufacturer to sell at former prices."
Incidentally it may be observed that all these endeavours recommended by Mr. Pixley to the auditor seem to be designed to secure that this asset shall be stated at the "realizable" value, which, as we saw above, was maintained by him as not being the true meaning of the figures set against the items on the credit side of a balance-sheet.
Everyone, however, will agree that the auditors cannot possibly be expected to value the whole property of the company every year before they certify the balance-sheet. We can expect them to verify the cash and check the prices of the quoted securities. Beyond that, although their skill and discretion and experience may be of immense service to shareholders, we cannot expect more from them than what they claim to have done in the usual ​form of certificate; that is, to have examined the balance-sheet and obtained all the information and explanations that they required, and decided that the balance-sheet is "properly drawn up so as to exhibit a true and correct view of the state of the company's affairs according to the best of our information and the explanations given to us, and as shown by the books of the company."
As to goodwill, opinion concerning the value of this item in a balance-sheet varies from the austere severity which argues that it ought to be written off altogether because there is nothing tangible behind it, to the more lenient judgment which considers that, however intangible, goodwill, which represents the reputation and popularity of a business and its products, is in some ways the most valuable possession that an enterprise can build up or acquire. Volumes might be written on the subject. Here it is enough to remind those who lay stress on the value of goodwill that this value, great as it undoubtedly is as long as the business is successful and the product is popular, dwindles very fast if the wind of popular favour shifts.
Enough has been said to show the investor that if he hopes by the scrutiny of balance-sheet and profit and loss account to arrive at ​conclusions concerning the position of an industrial company, he is only examining a set of figures, many of the most important of which merely express the opinion of the Board and management, subject to examination necessarily limited in scope by the auditors.
It may be possible to check the value of the Board's opinion by looking up its members in the Directory of Directors, seeing what are the other companies that they help to rule and investigating their prosperity. Investors are often advised to cultivate this system and it certainly has its value. But it does not take us very far because the best directors are often those who confine their attention to one or two companies, the affairs of which they understand thoroughly, and consequently have no extended record to show whether they are consistent winners. If, nevertheless, the investor determines to use the balance-sheet as a guide he should be careful to study it in comparison with its predecessors; and to facilitate this comparative study balance-sheets might all be drawn up, as some are now, to show the figures of yesteryear, side by side with those of to-day.
It is true that by this method the student may be multiplying the possibility of error, because the policy of the company in the treatment of its arguable assets may have ​varied—perhaps quite unconsciously—from one year to another. But at least he will be able to make intelligent guesses as to growth or decline, he can mark the amount (or the book value, which is not the same thing) of stock-intrade and draw doubtful inferences concerning the speed or sluggishness of sales of the company's products, and he may try to trace the financial strength of the company's position by noting the extent to which it is pledging its credit as compared with the amount that it is owed by other parties. Even here, however, it is dangerous to be too dogmatic. Critics of balance-sheets often pat companies on the back because the creditor item among the liabilities is less than the sundry debtors among the assets; and there is certainly a satisfaction in seeing that a company in which one is interested owes less than it is owed; but a big overdraft at a bank is the best guarantee of solvency that a company can have, and a large sum due from debtors may be only an indication that business is being pushed not by selling a good article cheap but by giving credit to purchasers, too many of whom will some day have to be provided for as bad and doubtful debtors.
Having wallowed so long among the quicksands which surround any attempt to test from a company's accounts the real extent of its ​profits, let us see if we cannot arrive at a small patch of solid ground. Let us take the profit for granted on our confidence—usually well based—in the integrity and prudence of the Board, and test our opinion of the company's soundness by the use that they make of it. As a rough generalization it may be said that this soundness will be in an inverse ratio to the proportion which the profit distributed as dividend bears to the amount of the profit declared. If only half the profit is distributed to shareholders all is very well (always barring the industrial risk that may overwhelm the best financed industrial concern); if nine-tenths of the profit goes in dividend things do not look nearly so well; if all the profit is distributed and still more if the dividend is only paid by drafts on reserves or on the amount carried forward, we are justified in shaking our heads, unless this action is accounted for by special conditions which are not likely to recur. But this subject deserves a chapter to itself.
* ↑ Commercial Goodwill. By P. D. Leake, pp. 61 and 105.
* ↑ Op. cit., p. 25.
* ↑ Duties of Auditors, p. 444.
* ↑ Chapter VIII, p. 120.