FINANCING THE
CHEMICAL
AND
PROCESS INDUSTRIES
o
As l o n g as a business is a g o i n g o n e w i t h reasonable outlook for g r o w t h and expansion t h e r e is some f i n a n c i a l a g e n c y w h i c h c a n h e l p it meet its c a p i t a l p r o b l e m s . . . The m e t h o d s u g g e s t e d h e r e is o n e r e l a t i v e l y n e w t o the c h e m i c a l a n d c h e m i c a l process industries
A l e w f deter i n Chemical FIncuMlng /JLS COMMERCIAL factors headquartered in Chicago, we have always been interested in the financial problems of mediumsized businesses—that is, firms whose annual sales volumes range from $100,000 to $5 million. For the past three years we have been running a study on these firms, and our findings seem interesting particularly to chemical firms, many of which fall within this range. Any reputable commercial factor is always approached by large numbers of prospective clients who have financial problems. In dealing with prospective and regular clients, we have tried to ascertain what their particular problem is as far as financial needs are concerned. In the main, over the past three years, we have found certain general facts about chemical companies. Sources for investment funds for small or medium-size chemical enterprises have dried up. Since the depression years of the 1930's, savings for investment have moved into securities of big-name chemical corporations or tax-exempt bonds. Even where it has been possible for medium size firms to sell securities with- some readiness, small issues are almost prohibitive in their cost, as they range up to 25% of the total issue. For ordinary stock flotations in amounts of $100,000 or less, clients tell us that regular channels of underwriting are practically nonexistant. Inability to Obtain Credit Small and medium-size chemical businesses, including many with good commercial ratings, have indicated to us, over and over again, that they have been unable to obtain term credit. Even on short-term borrowing, apparently sound firms have been cramped by inadequate bank credit. As far as the banks are concerned, long-term loans demand continuity of business, while small and medium-size enterprises are only as certain as the lives and continuing capacities of the owners. Restricted credit allowed by banks for working capital and current operations
VOLUME
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52
ROSS DUNWOODY, President, Dunwoocfy-O 'Bryan & Co., Inc., Chicago, §11. "O oss DUNWOODY was born in Joplin, Mo. -a-^- and quite naturally took his B.S. degree in economics at the University of Missouri, in 1932. Facing the icy breath of the depression at that time, he joined General Finance Corp. in Chicago as account executive in the new business department. In 1939 he organized DunwoodyO'Bryan & Co. and has been its president ever since, lie is also president of the Kappa Sigma Alumni Association of the University of Missouri, and has a son there. A few years ago one of Dunwoody-O'Bryan's clients needed financial aid to secuzre some chemical inventory. After some probing the company decided the chemical industry was here to stay, and since then it has greatly expanded its activities among chemical companies.
has compelled small and medium-size chemical businesses to depend unduly on rescue loans by finance companies. Fixed assets have been sold to replenish current funds. Many small and medium-size establishments are unable to take advantage of commercial discounts and are restricted to suppliers who will carry the slow accounts. Also, where applications of new developments require cash—such as the field of nonrayon fiber synthetics (nylon, Orion, Vinyon, saran, Azlon, Plexon)—a whole field for sales, production, and employment is being held back because of capital requirements and restricted credits. The cost of borrowing is much higher for the small and medium-size chemical firm than for the larger one, the differential being greater than the difference in risk would warrant. Even so, the percentage of credit refusals is much higher for smaller and medium-size enterprises than for larger companies. Part of the reason for this is that the bank's cost of keeping track of small loans and investments in small business is high, and even growing interest rates do not cover the expense.
* DECEMBER
2 5,
1950
Banks shy away from capital loans to small or medium-size businesses, and so long as banks remain repositories of funds which are withdrawn largely on demand, it will not be advisable for them to tie up their funds in equity capital investments. Reconstruction Pinance Corp. has been helpful in making some loans, but RFC's apparent insistence on prime collateral— because of the law under which it operates--has prevented many good firms from using this credit source. However, the stiff requirement has been responsible for keeping RFC's losses astonishingly low. After allowance for losses, RFC has earned $575 million over and above operating costs since 1932. This no doubt is commendable, but not too helpful to chemical firms wri.o do not possess prime collateral and yet have a legitimate need for capital loans. The traditional means of growth through plowing back of profits has been cut off by premium taxation against earnings needed for consolidation and expansion of the chemical business. Profit margins have been slimmer in the last half of 1949.
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Present indications a r e that the total corporate net income after taxes for all of 1949 will come to around $15 or $16 billion. T h a t is 20 to 2 5 % below 1948. W h i l e there seems to b e some disposition to look to t h e Government—or its agencies—for help, many of the clients ( o r prospective clients) interviewed felt that it is inconsistent with t h e objectives of p r i vate enterprise to ask t h e Government t o assume interests in private equities. W e find from clients in the chemical field t h a t their greatest need is for t e r m loans — which most medium-sized businesses have t h e hardest time getting. T e r m loans are credits d e m a n d e d for a period of time b y an enterprise seeking to take o n a n e w line, improve a plant, machinery, a n d equipment, or increase its working capital for purposes of expansion. Local banks have often m a d e term loans to a borrower acquiring new assets or for r e funding operations, and where banks h a v e provided repeated renewal of 60- and 9 0 day notes, a type of term credit has b e e n provided—but such terms place the business in a vulnerable position. Actually, our finding is that borrowing for expansion of sales requires a longer maturity, p e r h a p s o n e to five years, especially if t h e prices of industrial r a w materials continue to rise as they have been doing. In t h e present state of banking practice, it is highly unlikely that t h e required t e r m loans will b e forthcoming from commercial sources. It is equally unlikely that g o v e r n m e n t agencies will go overboard in lending such long-term money to smaller businesses. T h e Factoring Principle O n e possible solution to the problem has b e e n t h e use of t h e factoring principle. This is n o t a n e w device, b u t it is not well k n o w n in t h e chemical industry as a whole. T h e factoring principle merely assumes t h a t a company's accounts receivable are valuable assets and can be used to increase a firm's operating capital. W h i l e factoring is comparatively unknown in t h e chemical industry, it has been used for generations in the textile field, in shoe manufacturing, and in furniture. The Harvard Business Review of September 1949 estimates that about $2.5 billion annually is now going into industry from factors—money which is used as long term capital b y business and which stays in t h e business as long as it is needed. Only since t h e early 1930's has factoring begun to spread into the chemical field, and because tax laws have m a d e it impossible for chemical producers to accumulate sufficient capital to keep up with their exp a n d i n g industry, there have b e e n more a n d more calls on factors to supply permanent capital in this field. Last year, a Chicago chemical specialty manufacturer approached DunwoodyO'Bryan with a familiar and currently typical problem. T h e manufacturer was doing a business of $250,000 a year and had $50,000 tied u p in accounts receivable. H e could h a n d l e a volume of $400,000 if he h a d t h e necessary working capital. T h e additional 4540
requirement was about $30,000. Shortterm borrowing was not t h e answer since h e needed a permanent increase in working capital. H e h a d no desire for partners, a n d flotation of a security issue was impractical since t h e costs w e r e prohibitive. In addition to being unable to expand his production operations because of lack of capital, this manufacturer could not prudently sell to all t h e solvent concerns w h o wished to buy his goods. For exa m p l e , a large buyer w a n t e d a credit line of $10,000. But the manufacturer could not afford to extend such a line, because his working capital was only $50,000. E v e n solvent customers sometimes fail, a n d t h e manufacturer could not risk one fifth of his working capital on one customer. I n fact, the whole problem of credits a n d possible credit losses acted a s a serious drawback in a business of this size. Factoring, then, was the remaining possibility. T h e factor a p p r o a c h e d t h e situation first from t h e angle of eliminating credit risk and thus stabilizing t h e business. This he accomplished, after investigation, foy t h e outright purchase of all t h e manufacturer's accounts receivable, as at their maturity, without recourse to the m a n u facturer—that is to say, t h e factor assumed all responsibility as to credits. In plain language: Should t h e customers fail ( a n d some always d o ) , the factor shoulders the loss. T h e factor " a d v a n c e d " payment on t h e outstanding accounts receivable, u p to say 9 0 % of their face value, and handed t h e manufacturer a. check immediately for $45,000 less a few h u n d r e d dollars for factorage. T h e remaining 1 0 % was r e mitted w h e n t h e accounts m a t u r e d , usually not later than t h e 10th of the following month. T h e factor then assumed all of his client's new accounts receivable, a n d paid for t h e m w h e n t h e order w a s shipped, at their net face value less a small percentage. A Revolving F u n d T h e $45,000 now became a practically permanent revolving fund, expanding with t h e needs of the business. As fast as fresh sales w e r e m a d e , they were assigned, to t h e factor, who promptly m a d e the requested cash advances. T h e net result of this was that the chemical manufacturer obtained the required $30,000 for expansion of his business, plus $15,000 to spare. H e did not " o w e " this money to anybody; h e had not increased his capital stock or jeopardized his control of his business. Furthermore, h e was protected against all loss d u e to failure of customers. H e could, therefore, without hesitation, take on additional business u p to his $400,000-plus capacity, which h e did. A Chemical Processor Is H e l p e d Another illustration might b e helpful. A St. Louis chemical processor h a d a plant a n d equipment with a present -worth of $100,000; furniture a n d fixtures a t $4,600; equity in glass-lined kettles and
CHEMICAL
other e q u i p m e n t being purchased on time payments, $40,000; a n d trucks, $2,200— a total of $254,800. H e h a d $4,480 cash on h a n d a n d in the bank; accounts receivable, $56,000; raw materials, $4,200. H e h a d little merchandise inventory. Total quick assets a m o u n t e d to $69,680. On t h e liability listing he had a bank loan of $24,000; owed trade creditors $36,000; and h a d accruals, taxes, and so o n a m o u n t i n g to $6,400. This gave him a total of $66,400 liabilities, all current. To find out the amount of his net quick assets, h e deducted from the total quick assets the above liabilities a n d found h e h a d only $3,280 remaining. H e now understood w h y his bank h a d been pressing h i m t o r e d u c e his loan. The chemical processor w a n t e d to pay off t h e bank; and h e w a n t e d to put out two more salesmen t o take a d v a n t a g e of certain changed conditions favorable t o increasing his business. At the same time, his taxes and accruals should have b e e n b r o u g h t up to date. His needs were for p e r m a n e n t capital. A factor would give him advance of about $50,000 on his accounts receivable. Such a sum w o u l d be sufficient t o take care of his r e q u i r e m e n t s and p u t him in an easy cash position to handle the new business. The money so paid would expand or decrease w i t h his seasonal volume of business a n d he would b e p a y i n g only for the money actually used. This plan turned out to b e helpful and w o r k e d successfully. T h e customary functions and duties of a factor in the chemical industry might be p i c t u r e d something like this: The factor b u y s outright, without recourse, the receivables on the client's books. The transaction isn't a loan. There is no short term paper. T h e factor becomes the company's credit department; the factor collects from the company's customers in the name of the company. T h e factor stands all credit losses. T h u s puts the business of the company being factored on a 1 0 0 % cash basis. T h u s , each day as credit sales are made, they a r e converted into cash. T h e factor's compensation is in the form of a commission. T h e size of t h e commission depends upon the nature of t h e business a n d the credit risk taken. T h e client as a result c a n eliminate his credit department; h e c a n r e d u c e his bookkeeping costs; h e can eliminate collection costs. He can devote? his time either t o manufacturing or t o selling, or wherever his talents lie. In interviewing and studying t h e 428 firms discussed at t h e outset of this a r ticle, it was interesting to notice that some believed factoring was some sori: of borrowing expedient, or a refuge far shaky or shriveling concerns. O n t h e contrary, most factoring firms will decliixe t h e business of such concerns, because t h e factor's margin of profit is so small h e c a n n o t afford to waste time with a c c o u n t s t h a t are likely t o dry up or fail. F a c t o r i n g is designed for t h e otherwise prosperous manufacturer whose business is outrunning his working capital; it e n ables him fully and properly to utilize His
AND
ENGINEERING
NEVS
Table I. Balance Sheet of Photographic Materials Manufacturer _ Before Factoring After Factoring 2.2 to 1 Current ratio: 4.3 to 1 Current ratio: Cash on hand and d u e $ 3,500 Cash 57,000 from Factor $ 33,000 Receivables (less reserves ) 32,000 Inventories 32,000 Inventories Current assets 92,500 Current assets 65,000 145,000 Real estate and equipment 145,000 Real estate and equipment 237,500 210,000 Accounts payable 22,500 Bills and accounts payable 5,000 20,000 Notes payable 10,000 Notes payable to bank Current liabilities 42,500 15,000 Current liabilities Reserves for depreciation Reserves for depreciation 60,000 60,000 Capital and surplus 135,000 Capital and surplus 135,000 $210,000 $237,500
own resources without expanding his capital structure. Sometimes the need for more capital is brought about by a change in the economy. T h e development of quicker transportation and new packaging methods have r e d u c e d the importance of the chemical jobber. W e find, for example, that an increasing volume of merchandise is being sold direct from t h e factory to the retailer. As a result, the manufacturer who formerly had only a limited number of financially strong jobbing or distributing concerns on his books now has to carry a far greater number of customers and a larger total of receivables. This transition has been accompanied by an increasing reliance u p o n the factor to provide the facilities of his credit department and t h e additional funds for carrying the larger volume of outstanding receivables. This trend will probably continue, and may even b e accelerated, by the efforts of chemical specialty manufacturers to expand a n d diversify their lines. This will necessitate additional use of the factor's credit d e p a r t m e n t a n d funds for financing a larger a m o u n t of receivables. It m u s t b e said clearly, however, that factoring is not the sovereign balm for all the ills of business. It has drawbacks: It is usually more expensive than bank credit. That is because t h e risks are greater, and the factor's bookkeeping and credit checking are far more complicated than any bank's could possibly be. However, no matter w h a t method of raising working capital is considered, the true cost is arrived at in terms of t h e sales volume. In other words, to have any practical significance, t h e money cost should be figured per dollar of sales rather than per cent p e r a n n u m . For example, if a chemical company does a yearly business of $200,000 and the total cost of t h e proposed financing a year is $4,000, t h e n the money will cost two cents gross on every dollar of sales, or 2 % regardless of how the sum works out on an interest basis. From this gross cost should b e d e d u c t e d the present outlays t h a t will b e replaced or absorbed by t h e proposed factor's financing—such as credit investigation, collection expense and b a d debts, trade discounts not taken V O L U M E
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out, ledger bookkeeping—to give the net cost per sales dollar. It is not too much to assume that the company had been paying $500 a year for credit reports and losing a similar amount by not taking trade discounts. Thus the net cost of financing is reduced to $3,000 a year, or 1.5 cents per sales dollar. In some instances, factoring has become a permanent fixture in a business, although in some other cases it is regarded as a temporary measure. A chemical manufacturer near Cleveland h a d been doing a large catalog mail order business with dealers for some years. T o meet competition he decided to sell on longer open account credit terms to dealers. This plan succeeded—almost too well. It became necessary to raise over $400,000 of additional working capital. Since banking accommodations were out of t h e question a n d earnings were insufficient to warrant a stock issue, Dunwoody-O'Bryan was approached. The account was accepted, but because of the risk and work involved, a high rate was charged. Even though the rate was high, the mail order chemical producer was able to show a profit on t h e money a n d to build his business until, in two years, he could float
QUOTOOMS ( R E G . U. S . P A T E N T
OFF-ICE)
• • • I firmly believe in luck because I know its father well. His name is Hard Work.
Many persons without much push hang on for dear life to their pull.
Ideas are like money. You must put them to work or they wiU lose interest.
> DECEMBER
—O. (AI_L_ R I G H T S
2 5,
A. BATTISTA
RESERVED)
1950
a preferred stock issue and "clean u p " with the factor. A final case of a chemical producer in New England w h o has used factoring for the last three years may best be illustrated by his actual balance sheets. Table I shows the before-and-after balance sheets of a chemical company producing photographic materials. I n this case, the company had been dealing with a very cooperative bank in its area. But the company's business had expanded so rapidly that its d e m a n d on the bank was impossible, since commercial banks usually lend on general credit and the company's needs far exceeded its credit line. Turning to a finance company which lends on receivables, the chemical company found that it would still have to take responsibility for each and every receivable—that is, if the customer didn't or couldn't pay, t h e chemical company would have to make it good. It was only after a complete canvass of the private banking field that the chemical company discovered the commercial factor and learned that the factor purchases the receivables outright, with no further liability on t h e client. T h e only responsibility on the chemical manufacturer was to maintain standards of quality that were acceptable to his customers. Since those days three years ago, this photograhic chemical manufacturer has increased his annual sales volume 2.25 times, with, of course, a similar increase in t h e receivables purchased by t h e factor. It might seem unfair for the factor to take credit for this increase in volume; but, being free of the perennial chore of raising money to finance his increasing sales, this particular manufacturer could concentrate on raw material purchases, on fine production, and on energetic sales campaigns. I n the light of our study of 428 small and medium-size businesses, it becomes increasingly evident that between government tax policies and the rise in wage cost, raw materials, and overhead costs, many chemical companies find themselves squeezed for working capital requirements. The problem, however, differs from company to company, without any simple solution common to all. Some chemical companies might do well with straight bank credit, some with insurance company loans, some with chattel mortgage loans from finance companies, some by factoring their accounts receivable with factors, some by stock flotations, some by R F C loans, and so on. As long as a business is a going business, with reasonable outlook for growth a n d expansion, there is some financial agency which can meet that company's problems. All that is required is some energy and initiative on the part of the company managers in investigating the various sources of finance and evaluating what they have to offer for that particular business. THIS is the sixth and concluding article of C&EN's series on financing the chemical and chemical process industries. Other aspects of this broad topic were treated in the issues of Oct. 16, Nov. lrf. Nov. 27. D P C . 1 1 . and Dec. 18.
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