Sergei P. Dobrovolsky

English

Research Papers in Economics

This PDF is a selection from an out-of-print volume from the National
Bureau of Economic Research
Volume Title: Corporate Income Retention, 1915-43
Volume Author/Editor: Sergei P. Dobrovolsky
Volume Publisher: NBER
Volume ISBN: 0-870-14138-4
Volume URL: http://www.nber.org/books/dobr51-1
Publication Date: 1951
Chapter Title: Summary of Findings
Chapter Author: Sergei P. Dobrovolsky
Chapter URL: http://www.nber.org/chapters/c4830
Chapter pages in book: (p. 1 - 6)•1'
SUMMARY OF FiNDINGS
UNDISTRIBUTED corporate earnings have been widely discussed in con-•
nection with cyclical fluctuations in business activity, long-run trends in
investment and employment, changes in the economic functions of the
securities markets, and other economic problems. Yet the amount of fac-
tual information on corporate income retention policies is far from com-
mensurate with the general interest in their significance. This study
attempts to provide some additional information on the subject utilizing
various statistical materials. Though such an attempt hardly needs justifi-
cation, it may be useful to indicate what particular aspects of the subject
are dealt with and what light the findings of the study may be expected to
throw on broader economic issues.
The analysis was confined to the manufacturing sector of the corporate
economy, for the reason that samples of corporate financial reports were
available mainly for manufacturing corporations. However, in recent de-
cades this sector of the economy has been responsible, on the average, for
more than one-half of the income retained by all corporations. The main
object of the study has' been to ascertain whether corporate income reten-
tion has followed stable patterns during the years analyzed. It is commonly
known that the amounts of net income retained by corporations have
varied widely from one year to another and from one company to anothe.r.
But it may be inquired whether these variations in retained income have
been related, in a more or less stable manner, to some specific changes in
business or financial conditions. Two questions seem particularly relevant
in this connection: To what extent have variations in income
been associated with changes in corporate profitability? How closely have
these variations been related to changes in corporate investment?
The relationship of income retention to profitability is important in
connection with the broader problem of the relationship between national
income and national saving. Is our economy characterized by a stable "pro-
pensity to save"? Do we typically have so much saving at high levels of
national income that it becomes difficult to maintain an equilibrium be-
I2 Corporate Income Retention
tween the supply of and the demand for investible funds? Such questions
can be resolved only in the light of better factual knowledge than has been
available to date. Since corporate retained income represents a substantial
part of total national savings, a study of the corporate propensity to save
(that is, the relation between corporate net income and corporate saving)
should prove of considerable importance.
It has sometimes been assumed among corporation officials that sound
principles of corporate financial management require retention of 50 cents
out of every dollar of net income. If corporations typically followed this
"rule of thumb," the pattern of corporate saving would, of course, be
clearly defined and stable. The data on manufacturing corporations, how-
ever, indicate a different picture. While it is true that greater corporate
net income, whether measured in dollars or in percent of net worth, has,
in general, been accompanied by greater dividends as well as greater re-
tentions, the two components of income have not changed in equal degree
and the ratio of retained income to total net income has not been 50 per-
cent—or any other fixed percentage—at various net income levels.
ç analysis indicates that net income retention did not begin, gener-
ally speaking, until a certain minimum level of net income—approximately
5 percent of net worth—had been attained. Below that level dividends
were paid in excess of current earnings; that is, there was "dissaving"
rather than retention of income. Above that level corporate saving ap-
peared, representing at first only a small fraction of net income but increas-
ing in relative importance with increases in the level of income.
Uponexamining annual changes in net income, retained income, and
dividends, however, a fairly stable relationship appears for both low and
high levels of income. Thus, it is found that an increase in net income of
one dollar (per hundred dollars of net worth) has been associated, on the
average; with a rise in retained income of 70-80 cents, on the one hand, and
a rise in dividends of 20-30 cents (per hundred dollars of net worth),
on the other. Similarly, a decline in annual net income of one dollar (per
hundred dollars of net worth) has been associated, on the average, with
a decrease in retained income of 70-80 cents and a decrease in dividends
of 20-30 cents (per hundred dollars of net worth). In the language of
economic theory, it can be said. that the average corporate propensity to
save has varied with the level of net income, but that the marginal cor-
poratepropensity to save has remained the same at different levels of net
\ income.
This pattern of behavior is revealed by the aggregate data for all manu-Summary of Findings 3
facturing companies combined as well as by the samp.le data for large cor-
porations and for small- and medium-sized concerns. There are, of
course, many individual deviations from the average relation, the years
1936and1937, when the undistributed profits tax was in effect, being
outstanding instances; but, on the whole, the pattern appears to be quite
clear and shows a notable degree of stability over fairly long periods.1
The data for all manufacturing corporations combined show no signifi-
cant the corporate propensity to retain—either in an upward or
in a downward direction. In the case of large corporations, a small down-
ward trend is observed, while for the small- and medium-sized companies
the apposite tendency prevails.
In order to determine whether, in a given year, highly profitable com-
panies have, in general, retained more of their income than companies of
lesser profitability a cross-section analysis of a sample of large manu-
facturing corporations has been made. It has been found that although a
direct relation between corporate profits and saving rates is observable for
the years 192 5—26, it is difficult to observe any pattern for the years 1940—
41, when many highly profitable concerns retained surprisingly, small
proportions of their income. However, the contrast between these two
periods disappears when certain other factors affecting income retention
are analyzed. It is then seen that in both 1925—26 and 1940—41 an inter-
company difference of one dollar of net income (per hundred dollars of
net worth) was accompanied, other things being equal, by a difference of
about 70 cents in retained income and 30 cents in dividends (per hun-
dred dollars of net worth).
Among other factors affecting income retention, dividends paid in the
preceding period have been found of considerable importance. The rela-.
tion in this case is, as one would expect, an inverse one: lower previous
dividends were associated, other things being equal, with higher current
retentions. The rate of asset expansion and the size of earned surplus and
reserves also appear to have affected income retentions, although our
findings concerning these two factors are less conclusive.
In general, this analysis reveals fairly clear patterns of .corporate be-
havior with respect to net income retention. While the amounts retained
varied greatly from one year to another, and from one company to another,
the relation between net income and retained income remained fairly
1Thedata for all manufacturing corporations relate to the period 1922—43; those for
large manufacturing corporations to the period 1915—43; and those for small- and medium-
sized manufacturing corporations to the period 1917—43.4 Corporate Income Retention
stable over the quarter-century period studied. Unlesssome new factors
adverse to corporate income retention emerge in the future, itseems
reasonable to expect that so long as corporate profits remain high, cor-
porate saving will also remain high, providing substantial funds for
corporate expansion. If the business sector of the economy is to absorb
substantial amounts of personal savings in addition to funds obtained by
retention, ample opportunities and strong incentives for new investment
will be needed. This brings us to the second major question: What is the
relation between internal and external funds in financing corporate in-
vestment?
It has frequently been stated that income retention has tended to make
corporations virtually independent of the capital market and thus to
diminish the demand for external financing. This alleged trend toward
corporate financial self-sufficiency has been denounced as conducive to a
maldistribution of capital resources, on the one hand, and to a dearth of
investment outlets for personal savings, on the other. In connection with
these arguments, it is important to distinguish between the changes in
internal financing that occur at constant levels of corporate investment and
the changes in internal financing that occur when corporate investment
changes. Although it is obvious that at any given level of investment more
corporate saving implies less need for external funds, it is equally true
that under conditions of fluctuating investment requirements corporate
saving and external financing may increase or decrease
toascertain whether the degree of corporate
dependence on internal funds varies with the level of corporate investment
and whether the variations follow a more or less stable general pattern. In
addition, inflows and outflows of internal and external funds over periods
of cydical expansion and contraction have been examined.
It is known that manufacturing corporations have a high degree of
financial self-sufficiency as compared with other sectors of the corporate
economy. It is interesting to note, therefore, against this background, that
all manufacturing corporations combined dissaved, on balance, $1.7
billion over the nineteen-year period preceding World War 11(1923—41),
and their net absorption of external financing amounted to $5.5 billion.
Thus, the net expansion of physical assets in manufacturing over this
period of nearly two decades (about $4 billion) was financed, on balance,
entirely from external sources.
When the data are arranged according to phases of business cycles, it
can be seen that during the expansion phases manufacturing corporationsSummary of Findings
accumulated physical assets (that is, engaged in net investment) and that
they financed this activity from external as well as internal sources. In
contrast, during contraction phases manufacturing corporations reduced
their physical assets (that is, incurred net disinvestment) which was ac-
companied by a decline in the amount of external financing used as well
as by corporate dissaving. In other words, during expansions these com-
panies accumulated their own savings and absorbed outside savings, using
these resources for investment outlays and thus contributing to the
economy's expenditure stream. During contractions there was a reverse
flow of financial resources: corporate dissaving was incurred and external
funds were released through partial repayment of debt, stock redemption,
and the like. This process affected adversely the economy's expenditure
stream;2
Differences are found between the behavior of large manufacturing
corporations and that of small- and medium-sized corporations. During
the interwar period large manufacturing companies tended to reduce on
balance their use of external financing in both cyclical expansions and
contractions. They retained income on a substantial scale during expansion
phases, while their net dissaving during contraction phases was relatively
small. Small- and medium-sized companies showed rather erratic fluctua-
tions in both internal and external financing. Their' dissaving during the
contraction phases was much greater, relative to their income retention
during the expansion periods, than was that of large concerns. On the
other hand, small companies showed a tendency to absorb external financ-
ing mainly during periods of cyclical contraction.
Despite these variations, both large and small corporations have shown
a tendency to increase the use of external as well as internal funds with
increases in the rate at which their assets were expanded. At low asset
expansion rates income retention provided, in general, a sufficient amount
of funds or even more than was necessary to meet a company's investment
requirements. At higher asset expansion rates external financing was re-
sorted to, and the relative importance of external funds rose continuously
as the rate of expansion increased. It is true that the relationship among
income retention, external financing, and asset expansion is not as dose
2 It should be noted that, when dissaving is incurred as a result of the payment of divi-
dends in excess of current income, this may help maintain the stockholders' personal
expenditures and, to that extent, have a favorable effect on the total expenditure stream.
But corporate dissaving may also occur without an outflow of financial resources to other
sectors of the economy. Thus, if dissaving results from the fact that net income before
depreciation is insufficient to cover depreciation charges, it represents a reduction in the
owners' capital through wear and tear, unaccompanied by a release of funds.6 Corporate Income Retention
as that indicated by our analysis of retained income, dividends, and net
income. Obviously, other important factors are at work, and in some cases
the relative importance of external and internal financing was substanti-
ally different, even though the rates of asset expansion were approximately
• the same. Nevertheless, the general tendency for external financing to
increase in relative importance with increases in the rate of corporate in-
vestment is clearly discernible. This tendency is evident both when the rate
•of physical asset expansion and when the rate of total asset expansion are
examined, though the pattern of relationship is somewhat closer when
financing methods are related to the growth of total assets. Furthermore,
this general tendency for external financing to gain in relative importance
at higher expansion rates is revealed by studying intercompany differences
at a given time as well as by analyzing variations over a period of time.
Finally, it is important to note that, although there are many individual
deviations from the general pattern of relationship, no general tendency
can be observed for the ratio of internal to external financing, at given
rates of corporate investment, to change over the period of time examined.
In other words, allowing for variations in the rate of corporate investment,
manufacturing corporations seem not to have become either more or less
financially self-sufficient.
Our findings, therefore, point to the conclusiOn that the amount of
funds absorbed by corporations from the capital market has depended
primarily on the rate of corporate investment. Changes in the degree of
dependence on external financing were associated with changes in the
level of investment activity rather than with changes in corporate "pro-
pensity to save" or "propensity to borrow." Unless future patterns of
behavior change radically, it would appear that corporations will continue
to draw heavily on the capital markets when their expansion is rapid, but
that internal financing will be adequate when net investment is slack.

Corporate Income Retention, 1915-43

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