# Hints About Investments/Chapter 8

When the investor turns from public debts to enterprise, he walks out of a mist into twilight. We have seen how much guesswork and obscurity surrounds the question of the solvency of a Government or a public body, and how much faith and sentiment is needed by those who put money into the debts of the best of them, in the hope that it will be safe for twenty years or so. When we come to examine the question of the earning power of a company, we are faced by the baffling cryptogram of the balance-sheet, more interesting as a puzzle than informing as a statement of fact, and the apparently more illuminating record of the profit and loss account, which, however, merely tells us what the directors, usually in the best of good faith, think that the company has earned. But profit, as Mr. Wells says, "is the economic riddle that still puzzles us to-day."
Concerning the efficiency of balance-sheets ​in misleading—"lying in every line" as he puts it—language much stronger than I should care to use has been employed by Sir Josiah Stamp; as a leading official of the Inland Revenue office and the director and secretary of a great industrial company with interests in many others, he has had unique opportunities for judging figures as exponents of facts. Usually a restrained writer, fond of the apt and judicious rather than the emphatic phrase, he holds the loud pedal down hard when he deals with the balance-sheet. As witness:—
"Our modern fetish of a 'safe' or 'sound' balance-sheet . . . lies in almost every line and yet is approved professionally because it overstates no assets and understates no liabilities, while it has valuable premises written down to negligible figures and reserves hidden in innumerable places, or profits 'held up' and 'tucked away.' 'The truth, the whole truth and nothing but the truth' cannot be derived from the modern balance-sheet so vaunted for its prudence; but prudence is just as possible without departing from what a balance-sheet ought to be—a faithful record of the employment of the total capital invested in the business, whether as an original outlay or retained profits, from which the true rate of profit on invested capital can be determined. ​Has the shareholder, who wishes to sell his holding, no rights as to some real knowledge of the value of what he is selling? . . . If it is said that all we are concerned with in the balance-sheet is that it is a final clear up of the accounts, I have nothing more to say. If you say two balance-sheets of the same concern can be quite different and yet both be equally accurate and true and desirable, I have nothing to say. When I was a surveyor of taxes, I often had people coming to me with sheets of paper and saying, 'Well, I do not keep much of accounts, but I have made up that for the bank manager, and it puts the best face on things.' One day I was talking to a bank manager friend, and he said that people often came to him with accounts and said, 'Here is a thing I had to prepare for the tax people, and so I am at least as right as that.' To one it was to be a maximum, to the other a minimum. Ought the balance-sheet to be a thing you can pull this way and that? If that is our idea, it may well be that it is destined to be radically changed in the next generation. Now, why the financial community should acquiesce in a condition of things in which a balance-sheet can be almost anything I cannot imagine. Auditors' certificates refer not merely to it being corect accord​ing to the books, but truly and faithfully representing the condition of the business."
This exposure of the value of a balance-sheet as a guide to investors and shareholders is all the more significant and suggestive, in that it was uttered in the course of an address delivered at an annual conference of the Society of Incorporated Accountants and Auditors.
Nevertheless, it is the only guide, with or without a profit and loss account which is based on it, that is vouchsafed to the public by a large number of very important companies and it cannot be left out altogether, much as Sir Josiah's words would tempt one to save time, space and patience by leaving the balance-sheet buried under the heap of contumelious epithets that he has piled upon it.
When one picks up a balance-sheet one sees two lists of things with figures against them on one side and the other of a sheet of paper, usually with a dividing line down the middle. The left side, in English practice, is headed Liabilities, or Dr. (signifying debtor) and the right side Assets, or Cr. = Creditor. It thus shows on one side what the Company owes, on the other what it is owed or has got. The difference between the value put on the assets ​and that of the liabilities is the balance, which is profit, and is available for distribution as dividend or allocation to reserve, or to be carried forward to next year. It is added to the figures of the liabilities to make the two sides agree. If the company has made a loss, the assets are less than the liabilities in value, and the balance appears on the assets side.
It is sometimes disconcerting to the uninitiated to find the company's capital and reserves among its liabilities, because they think that these are items which it must have got and must possess and that therefore they ought to be among the assets. But a moment's thought makes it clear that the capital is the money subscribed by the original shareholders and is consequently owed, and has to be accounted for by the company to them, which it does by showing assets on the other side, in which the money has been sunk; and likewise the reserve fund has been built up out of sums reserved out of profits, or received by the issue of shares at a premium, and similarly is owed to the shareholders.
The sum put down under capital sometimes includes shares that have been issued, not against money subscribed, but in part payment for the business acquired, if the company bought an existing business, or for services ​rendered in starting the enterprise; but this is a complication that need not detain us. The stock or shares have been issued against "value received "or thought to have been received, and so their owners are part proprietors of the company to whom it has to account for the sums credited to them.
After this preliminary survey let us look at the details of a comparatively simple balance-sheet and see how much it tells us that would be a trustworthy guide to a shareholder or to anybody who was considering a purchase of part of its debt or share capital. Here is the slightly simplified balance-sheet, as on June 30, 1925, of Messrs. Bass Ratcliff and Gretton, famed as brewers wherever the English language is spoken, and in a few other places besides:—
| Liabilities | Liabilities | Assets | Assets |
| Creditors | £1,923,348 | Cash | £585,350 |
| 4½% Deb. Stock | 1,360,000 | Investments | 1,823,926 |
| 3½% Deb. Stock | 560,000 | Bills receivable | 5,674 |
| 5% Pref. Stock | 1,360,000 | Debtors on Trade Account | 1,308,064 |
| Ord. Shares | 2,040,000 | Stocks of Hops, Ale, etc., and movable plant | 1,406,198 |
| Reserve Fund | 950,000 | Freehold breweries, etc., and fixed plant | 1,160,514 |
| Profit and Loss | 420,097 | Licensed properties and trade loans | 1,523,719 |
| £8,613,445 | £8,613,445 | Goodwill | 800,000 |
| £8,613,445 ||||
The outside claimants (debenture holders and creditors) against Messrs. Bass are owed £3,843,000 out of a total of over £8,613,000 millions; so that if the company went into liquidation and the assets realized the values placed on them, there would be £4,770,000 to be divided among the shareholders. The preferred shareholders having been paid off at par, there would be £3,410,000 for shareholders, the face value of whose claim is only £2,040,000, giving them an apparent bonus of £1,370,000 among them. This increment, however, is by no means "unearned," being exactly accounted for by the Reserve Fund, accumulated out of past profits, and the Profit and Loss balance of £420,000 which belongs to the shareholders on the assumption that there were, at the date of the balance-sheet, ​no arrears of interest or dividend due to debenture holders or preference shareholders.
From the point of view of the creditors the position is different, but quite comfortable. They rank first, but, naturally, only to the extent of their claim. All that concerns them taken as a whole is to be sure that out of assets valued at over 8½ millions, their aggregate debt of £3,843,000 will be met in full, and the margin is surely large enough to satisfy the most exacting, especially when they notice that debtors, investments, cash and bills receivable come to £3,723,014, almost enough to satisfy them, without disposing of any of the freehold brewery site and buildings, or the tied houses, or the stock of materials and beer made and in the making, to say nothing of that elusive and incalculable item, the goodwill.
Creditors, as need hardly be said, are not an aggregate all on the same basis, and anyone contemplating a purchase of Bass Debenture stocks would have to be careful to see in what order they rank in priority of claims and how much power the directors have to put claims ahead of them in borrowing money for the purposes of the business. But when all this has been investigated it will appear that the position is as sound as a straightforward ​balance-sheet can make it, with an article of world-wide consumption and fame behind it.
But now let us see what a sour, jaundiced, liverish critic—and it is in this spirit that the prudent investor will scan every financial statement put before him—can say against the attractions of the Bass balance-sheet.
He will begin by pointing out, with perfect truth, a defect that is common to nearly all balance-sheets—all, it may be said, except those in which the assets consist of nothing but cash in hand or at a first-class bank, and securities quoted, and actively dealt in, on the Stock Exchange. This defect is that whereas the liabilities give you figures which are certain facts, the assets are expressed in figures which are, with the exception of the cash and investments mentioned above, to a certain extent a matter of guesswork. The figures may be too high or too low (our liverish friend, of course, will assume that they are too high), but it would be a miracle if any of them proved to be exactly correct if the assets were sold.
Cash is a definite and known amount; securities quoted on the Stock Exchange may reasonably be expected to be sold at or near the prices at which they have lately changed hands. But when we come to half-brewed beer in vats, and still more when we come to ​bricks and mortar in the form of breweries and public houses, the difference between what they may be expected to be worth and what they may actually fetch may be very considerable.
To point his moral and adorn his tale, he might cite the recent reconstruction of Vickers, Ltd., in the course of which it was found necessary to write more than ten millions off assets standing at 22¼ millions, and further to provide 2¼ millions to meet "contingent and other liabilities expected to accrue." (Economist, December 12, 1925.)
After this general denunciation of all balance-sheets, the critic would proceed to dilate in detail on the one before us. First of all, he would say that even assuming the figures of the assets to be correct, the position only represents the present situation of a business which is a highly prosperous member of a trace which many people believe to be doomed, because the consumption of alcoholic liquor is alleged to be diminishing; nearly the whole of the North American Continent is already (or is supposed to be) dry; and some prophets tell us that in a decade or two the social and economic results of the American experiment will be so overwhelming that the rest of the world will be driven perforce on to the water ​wagon. In that day Messrs. Bass, if still existing, will be brewing ginger beer.
In the meantime there would be a bad time of dwindling demand to go through, and on the assumption of this bad time the critic will proceed. Cash, he will say, looks very nice at half a million and more, but if bad times came and it were necessary for the brewers to fight for the diminishing thirst of the public there would not be nearly so much of that cash before the fight had gone far. The same thing can be said of investments. It is an imposing total, but even supposing that they can be sold to realize the price—and we all remember days in 1914 when very few securities could be sold at all—would the total still be as imposing after a few years of depression in the drink trade?
And these are the plums in the assets pudding, because their value does not depend on that of beer; the jaundiced critic would only begin to enjoy himself when he proceeded to deal with the others. Debtors and bills receivable, he would say, are, or may be, very good assets as long as brewing and selling beer is a prosperous business, but if it were afflicted by misfortunes that affected Messrs. Bass, their debtors—the trade connections who have been supplied on credit—would almost certainly be affected even more severely, and who knows ​how much they could pay? And stocks, brewery premises and tied houses are inevitably all in the same beer-logged boat. The sort of critic we are imagining might even be guilty of making a bad pun about assets being sometimes too liquid, when liquor is out of fashion.
But when he comes to goodwill, he will really open his shoulders and slog. For he will tell us, which is true, that goodwill is an item never seen in the sort of balance-sheet that is produced by the elect of the financial world, the banks and insurance companies, and will go on to say, what is much more doubtful, that it has no right to be in any balance-sheet at all, but ought to have been written off years ago out of profits; and that this is a case in point because the value of the Bass goodwill depends entirely on the fame of their beer, and if the public gives up drinking beer, this value becomes a vanishing quantity.
Finally such a critic might add that any balance-sheet is worse than useless as a guide to the position of a company, because the people who draw them up, and the authorities whose business it is to examine them, have not yet made up their minds on the very important question as to what a balance ought to show, whether it should set out to display the way in which the company's money has been spent, or ​should try to indicate the sum that the assets might, if sold, be expected to fetch.
This criticism is unfortunately true. If you look back a few pages at Sir Josiah Stamp's observations with which this chapter began, you will see that even this very clear-sighted examiner of balance-sheets expresses himself with a certain inconsistency. He tells us very clearly what a balance-sheet ought in his opinion to be—namely a "faithful record of the employment of the total capital invested in the business, whether as an original outlay or retained profits." This surely can only mean that what should be shown is all the money that has been spent in purchasing the assets and in making provision against the inevitable decline, owing to depreciation by wear and tear and "obsolescence," in their value. In other words the full amount charged against depreciation of wasting assets: (such as machinery, plant, etc.) and against provision for doubtful debts, declining value of investments and other such precautionary expenditure, should be clearly shown either by being put down as written off certain assets or included in a depreciation fund among the liabilities, the assets being left at the sums that they cost.
This system would certainly give us a ​balance-sheet which would clearly represent some quite important facts. It would be contrary to the general practice, by which directors do not state the full amount that is taken from revenue for this purpose, with the result that there are, as Sir Josiah says, "reserves hidden in innumerable places," and in the case of ill-financed companies, there are undisclosed losses in equally numerous spots.
But then, if this be what a balance-sheet ought to be, it will break down under the next demand that Sir Josiah makes upon it. "Has the shareholder," he proceeds to ask, "who wishes to sell his holding no rights as to some real knowledge of the value of what he is selling?" And this surely must mean that the balance-sheet ought to show not what has been spent upon the assets, but what they ought to be expected to fetch, if sold; or to cost, if they had to be replaced. If this be the true basis of a balance-sheet, a company would not only be entitled, but obliged, in times of rapidly rising prices, to write up the value of those assets which had risen in price.
Equally confusing to the layman, who endeavours to cull wisdom from the sayings of these learned authorities, are the observations of Mr. Pixley in his Duties of Auditors that has ​gone through so many editions. In his chapter on the Credit side of Balance-sheets, he begins by insisting that there are strong reasons for not calling it the Assets side, and says the "professional accountants, who themselves used the term for many years, have lately been impressed at the meaning endeavoured to be put upon it, it never having previously occurred to them that anyone could truthfully assert that they believed that the amounts opposite the items on the credit side of a balance-sheet were their realizable actual value."
But this actual realizable value seems to be just what Sir Josiah Stamp thinks that a shareholder ought to be able to see. Moreover, Mr. Pixley himself, on the very next page, says that "at the same time it must not be understood that an auditor has simply to ascertain that the amounts taken credit for in the balance-sheet in respect of property or assets are merely their book values. Prior to the auditor commencing his duties, the figures to be inserted in respect of these items have, of course, to be settled by the directors, and the groundwork upon which they have to arrive at the figure to be taken credit for in respect of each item is, of course, the balances of the Ledger Accounts. This is also the basis from ​which the auditor starts in his endeavour to satisfy himself that the amount finally decided upon by the directors is, or is not, correct." He starts from the book values, but the use of this word evidently implies that he does not stop there. Where does he go next, and where does he arrive finally, and by what test does he satisfy himself that the figure finally decided upon by the directors is, or is not, "correct"?
If the realizable value of the assets is what ought to be shown, it is evidently a matter of guesswork because the realizable value of anything, except a very few securities and commodities in which there is a quoted price and a really free market, can only be known by taking it into the market and selling it. Moreover there will be a very great difference in the guesses that we shall make at it, according as we decide whether realizable value is to be old iron, scrap-heap value, or value as a going concern. If, by a great effort of the imagination, one could conceive the Bass brewery as a derelict failure, the value of its site, buildings, machinery, plant, book debts would be x; the value of these items as parts of a great concern that is earning a profit of nearly half a million pounds a year, is, or may fairly be argued to be, x multiplied by something considerable. But ​as to what this "something considerable" should be, is a matter in which opinions will differ enormously. And the question is all the more complicated because it will clearly depend on the rate of profit being earned, and the rate of profit depends on the view that is taken concerning the value to be placed on the assets.
For if the figures of the assets, or the items on the creditor side, need to be reduced or raised in order to be a "correct statement," the difference between the assets and the liabilities will be altered, and this difference is what makes profit.
Let us see by means of a very much simplified example, how the process works of arriving at profit. Let us suppose a little company starting with a balance-sheet like this:
| Liabilities | Liabilities | Assets | Assets |
| Capital | £200,000 | Cash | £5,000 |
| | | Materials | 50,000 |
| | | Buildings and Plant | 145,000 |
At the end of its first year it has worked up its stock and sold it for £100,000, paid £20,000 in wages, taxes and all other expenses and replaced its material at a cost of £50,000. It has (in order to simplify) worked entirely on a cash basis and so has received £100,000 ​and paid out £70,000 and its position will be stated thus when the directors come to draw up the balance-sheet for public issue.
| Capital | £200,000 | Cash | £5,000 |
| Balance | 30,000 | Materials | 50,000 |
| | | Buildings and Plant | 145,000 |
| | £230,000 | | £230,000 |
The amount of net profit finally shown will depend entirely on the view that the directors take about the figures to be put into the final balance-sheet against the items on the credit side apart from cash, which is a known quantity. Material may have fallen in value since they bought it and there may be much discussion as to whether it ought to be written down by io per cent., by 20 per cent. or by nothing at all. The machinery and plant, being brand new, some will argue that there is no need to write them down at all, while the more prudent will urge that their ultimate destiny is the scrap-heap, that the mere fact that they have done a year's work takes about 50 per cent. off their value for selling purposes and that a start ought to be made at once with the writing down process.
If compromise is finally reached on the basis of a 5 per cent. all round reduction in ​the doubtful assets, the balance-sheet will be drawn up thus:
| Capital | £200,000 | Cash | £35,000 |
| Profit | 20,250 | Stock | 47,500 |
| | | Buildings and Plant | 137,750 |
| | £220,250 | | £220,250 |
If no writing down is decided on, the profit will remain at the original £30,000; if 10 per cent. is taken off the doubtful items, it will come down to £10,500.
This simplified example shows us that the profits shown as earned by all profit-earning concerns, depend ultimately on what the directors think about the figure to be set upon those assets in the balance-sheet, the value of which cannot from their nature be definitely ascertained, without the expensive and tedious process of expert valuation which also is liable to error. The opinion of the directors is subject to comment by the auditors and criticisms by the shareholders, but, as a general rule, their decision is final. As has been shown, the problem that they have to consider lends itself to argument, and is open to wide differences of opinion on the part of people who are honestly trying to do the right thing; and the conclusion of these honest, but fallible, gentlemen decides the profit that is earned.
​It may be said that their decision can only modify the amount of profit shown, and could not make a loss into a profit. Ultimately and in the long run, this is certainly true, for bad finance brings its day of reckoning; but the day is often delayed, and in the meantime book-keeping agility can perform wonderful feats.
Moreover it must be noted that a particularly clear and simple balance-sheet was chosen as the specimen for examination. In those of the great industrial combines, whose assets consist largely of securities of other companies, all the doubts and difficulties that have faced us are many times multiplied.
What is the practical conclusion to be drawn by the investor? It seems to me to be this, that since the value placed on most of the assets of a balance-sheet is, to a great extent, a matter that can only be guessed at, and is actually arrived at by the opinion of the Board of Directors, the most important asset that a company can possess, after, and perhaps even before, the technical efficiency in production that its business requires, is an honest and prudent Board. Fortunately this asset is possessed by the great majority of companies, because without it they would very soon perish. But there are degrees, and the personality of ​the Board and the traditions under which they conduct what may be called the balance-sheet side of the business is not only of the highest importance, but is also a matter on which the ordinary investor is likely to have even less information than upon the conditions and prospects of any enterprise in which he is interested.
Having thus bewildered and puzzled ourselves by trying to discover what a balance-sheet is meant to convey and finding that on its credit it consists chiefly of figures that may be too low or may be too high, but are almost certain to be an inadequate guide to the value of the business, let us go back to the Bass balance-sheet and see what sort of reply the Board would make to the observations of the ultra-critical critic which were set forth above.
They would probably admit
(1) That the figures set against most of the assets can only be arrived at by taking their cost price and writing off from it whatever sums the Board thinks right to deduct for depreciation and that consequently these figures are a matter of the Board's opinion. Nevertheless they would say
​(2) That a good and honest Board, such as most companies possess, assisted by the highly trained skill of the auditors, does its best to make full and sufficient provision for depreciation and is in fact likely to err on the side of providing too much rather than too little, with the result that they are flayed by Sir Josiah Stamp for having "hidden reserves" and "profits tucked away";
(3) That since there can be no certitude, it is surely better to understate rather than overstate the value of doubtful assets; and that a good balance-sheet should try to state them at, or below, their realizable value.
(4) That all the dismal vaticinations of the imaginary and imaginative critic about the day when England will be dry and Bass will be brewing ginger beer, and all the present breweries, tied houses, plant, stock, goodwill and book debts will be of problematical value, is beside the mark; because a balance-sheet is not meant to be a prophecy showing what the business is going to be doing in twenty years' time, but a picture of its condition to-day and that all that a ​Board can do is to draw that picture as accurately as it can.
(5) That as to goodwill, the balance-sheet might easily have been made prettier in the eyes of many critics, if instead of amassing a Reserve of £950,000 the Board had written off, as they could evidently have easily done, the whole of the £800,000 at which goodwill is valued. But that nevertheless under modern conditions of industry selling power is almost, if not quite, as important as power to make a good article, that a Bass label on a bottle has a quite miraculous power as a seller, and in short that if there be any enterprise in the world that has a right to set out its goodwill as a valuable asset, that enterprise is Bass's brewery.
After which the chastened investor, having discovered that the soundness of a balance-sheet depends chiefly on that of the Board, as to which he is largely in the dark, and that he cannot expect it to tell him the future, which is what he really wants to know, may well ask whether nothing can be done to make balance-sheets more informing, and, if not, what other ​test he can take if he tries to judge for himself concerning the prospects of a company. Before we try to answer these questions let us see what light is thrown on the question by the Profit and Loss Account.
* ↑ Outline of History, Chapter XXXVII, § 11, p. 608.
* ↑ Current Problems in Finance and Government, by Sir Josiah Stamp, G.B.E., D.Sc., p. 14.
* ↑ Pixley's Duties of Auditors, p. 468.