Let us return to the report and balance-sheet of Messrs. Bass, Ratcliff & Gretton and see what the directors of this company do with the profit at which they arrive after making the provisions recorded in the last chapter.
According to their statement in the report the profit amounts to £537,000 before charging interest on Debenture Stock, but since interest on Debenture Stock is a charge that has to be met, unless a company is prepared to compound with its creditors or commit an act of bankruptcy, it seems to be sounder and more logical to take off this interest, which comes to £81,000 for the year, before we arrive at the profit which the Board may or may not distribute to shareholders. On this basis Messrs. Bass's profit for the year to June 30, 1925, was £456,000.
Of this sum £68,000 goes in dividend on the preference stock, and £265,000 in dividends and bonus on the ordinary shares, making a total of £333,000 distributed.
Reserve Funds receive £150,000 in all, but, as the amount carried forward is reduced by £27,000, the net amount actually put away is £123,000.
Thus, out of a total profit of £456,000 the directors distribute £333,000 (or roughly 73 per cent.) and hold back £123,000, or roughly 27 per cent.
The calculation can be made still more favourable if we deduct from the Profit the sum due to the Preference shareholders, whose rights and position will be discussed in a later chapter. Preference dividends can be "passed" (that is to say, left unpaid), without involving a company in bankruptcy, since they are a payment due to proprietors or partners in the business and not to creditors; but as in this case they are cumulative, which means to say that until they are paid the ordinary shareholders can receive no dividend, and as any prosperous company pays its preference dividends as a matter of course, and as punctually as the interest on its debts, it cannot be contended that they are an optional payment in the same sense as dividends paid on ordinary capital.
On this system we arrive at £388,000 as the really divisible profit, after providing for debenture interest and preference dividend. Out of this £388,000 the directors pay £265,000, or 68 per cent., in dividend and hold back £123,000, or 32 per cent.—not far off a third.
It has also to be noted that the allocation of £50,000 to Reserve Fund raises it to a million, or nearly half the amount of the ordinary capital, which stands at £2,040,000, so that shareholders who are hungry for large dividends (as all human shareholders naturally are in view of the risks that they take) may feel that the directors have done quite enough in the matter of piling up reserves out of money which might have increased the current income of shareholders. And we find in the Report a sentence which indicates that the Board feels that it has to explain its action in pursuing still further the policy of building up reserves. For they observe, after stating that the total distribution to ordinary shareholders recommended is 11 per cent. and a bonus of 2 per cent., "it is also proposed to place £50,000 to Reserve Fund (which will then amount to £1,000,000) and, in addition to the regular yearly amounts written off the Property Account, it is considered prudent to provide a further £100,000 for depreciation," etc. More over they also add, what appears to be a sentence that is inserted regularly in all their reports—"the directors consider that they have made sufficient provision for contingencies which may be reasonably foreseen."
So having built up an ordinary Reserve Fund of a million pounds, they have now started a new fund called Reserve for Property Depreciation, with £100,000, of which £27,000 comes out of the amount carried forward out of past profits and £73,000 out of the profits of the year under review.
It is this policy of building up reserves which has to be explained and almost apologized for to shareholders, which gives the ordinary shareholder in a prosperous company the great advantage that the value of his property is continually increased for him by an act of periodical saving and reinvestment, which is carried out on his behalf by the Board, and brings compound interest in to work for him with its rapidly accumulative effect.
In this case it has made him not only a shareholder in what is perhaps the best-known brewery in the world, but also a part proprietor in an investment company which holds investments standing in the balance-sheet at £1,824,000 and so not far from covering the whole of the ordinary capital of £2,040,000. These investments are described as in "British Funds, Colonial and Foreign stocks and bonds; railway preference stock and sundry debentures and shares," and as standing "at or below current quotations or valuations." The curious, of course, would like to know something as to the proportions which these very various classes of securities bear to the total invested, and a full list of the investments held would evidently make this item in the balance-sheet much more interesting. We shall find, however, that many of even the purely investment companies think it advisable not to let the public know in what securities the funds entrusted to them by their shareholders and creditors are placed; and there may be good reasons for this reticence, that are not evident to the layman.
By the reserve fund policy the shareholder is given an increasing value in his property through the retention by the Board of money that has been earned for him and its reinvestment either in extension of the enterprise or in holdings of the shares of companies in which the enterprise is interested or in outside securities.
This policy has one drawback—it misleads critics, especially those who fancy that there is something wicked about earning profits, by exaggerating the apparent return on the company's capital. For instance if a company with a capital of £1,000,000 has accumulated reserves of £500,000 and earns a profit of £150,000, it seems to be earning 15 per cent. on its capital of a million, but what it is really doing is to earn 10 per cent. on a total capital of a million and a half, because the half-million of reserves is in fact fresh capital that has been added out of profits. It is thus liable to be called a blood-sucking exploiter earning 15 per cent. out of the patient public, whereas it is only earning 10 per cent. for its patient shareholders who have seen part of their profits held back year by year and put into the expansion of the business.
To correct this misapprehension and secure the acquiescence of the shareholders in the continuance of the reserve fund policy, it is now a common practice for Boards of Directors to capitalize reserve funds or part of them by an issue of bonus shares, that is by an issue of shares to shareholders without payment on their part, by the conversion of reserves into shares.
If we return to the example just imagined, of a company with a capital of £1,000,000 (and suppose that it is in £1 shares) and reserves of £500,000, the reserve would be capitalized by the issue to the shareholders of one new share for every brace of shares held. The result would be that on the liabilities side of the balance-sheet instead of seeing
| Capital | £1,000,000 |
| Reserve Fund | £500,000 |
the legend would run:
| Capital | £1,500,000 |
and the Reserve Fund would be wiped out, leaving a clean space for the Board to begin building it up again.
This operation of capitalizing reserves is usually hailed as a "bull point" by shareholders and speculators, and is presumed to confer some juicy benefit on the former. In fact it merely gives them in the form of shares what was already theirs in the form of reserves. It has no effect whatever on the assets or earning power of the company, and unless the profits increase the shareholders will in future receive no more in dividend from their larger holding than they would have had if no such change had been made.
The real advantage of it is that it shows more clearly the true facts of the case and the true rate that the company is earning on the capital that its shareholders have actually put into the business or have had put in for them by the Board. It also pleases and cheers the shareholders and makes some of them think that they are better off, and reconciles them to seeing the Board building up the reserves in later years, and so continuing the process by which their property and earning power are expanded.
Some companies can achieve the same result—an increase of capital through the channel of reserve funds—by issuing shares, to their own shareholders or to the public, at a premium. It goes without saying that in order to do so their shares must stand high in the market.
We thus find that though the profits shown as earned by a company are, as a test of its position, full of misleading uncertainties, the use that the Board makes of the profit declared has some significance. We are in touch with definite fact when we ask how much of the profit remaining after meeting all charges, including preference dividend, is paid away in dividend and how much is put to reserve or added to the amount carried forward.
In its quarterly examination of the profits of industrial companies the Economist works out the proportion of profit put to reserve. The average shown by the 1,443 company reports examined during the four quarters ending June 30, 1925, came to 22.3 per cent. But the Economist arrives at its proportion by including preference dividends as part of the sum distributed out of net profit. It seems to me that one gets a fairer result by deducting preference dividend—as practically a fixed charge—from net profit in order to get the divisible balance. There is then the true balance left, which may be distributed in ordinary dividend or carried to reserve or added to the amount carried forward, and it is the division of this balance which is of some use as a test. On this basis the average performance of the 1,443 companies whose reports were investigated by the Economist works out at 72.2 per cent. to ordinary dividend and 27.8 per cent. to reserve or kept in hand.
As need hardly be said, the test is far from precise, for variations in the form of the companies' capitals and debts make the comparison, to some extent, misleading. But as a rough guide in a country where pitfalls are plentiful and signposts are mostly incorrect, it may be better than none. It leads us to the conclusion that the investor may be well advised to insist that any company in which he invests is at least up to average in this respect.
It is interesting to note that in America industrial companies as a whole appear to distribute only half their earnings as dividends. So, at least, it is stated on page 142 of Messrs. Foster & Catching's lately published book on Profits. Possibly the high proportion of water in the capital, that is usual at the outset in American industrials and is squeezed out gradually by allocations from profits, accounts for this apparently austere ideal on the other side of the Atlantic.