the termination of the war and if these provisions are rigidly applied in the light of peacetime standards, the average company could face risks which it is at present in a very poor financial position to meet.

Special considerations, cost-plus-fixed-fee contracts.

It would seem reasonable to assume that the possibilities of loss in canceling a cost-plus-fixed-fee contract may be less than in the case of a fixed-price contract. The Government machinery for approving costs and reimbursing the company has already been set up under a cost-plus-fixed-fee contract, and a substantial amount of the inventory has been paid for by the Government; when a fixed-price contract is canceled, many costs are approved for the first time by the Government and then reimbursement for inventory is made.

Furthermore, resident representatives of the Government, who have been present at each plant, have been administering regulations to safeguard the Government's cost-plus-fixed-fee property. They have built a more elaborate record of basic Government data than is likely to exist for fixed-price contracts. This does not mean, however, that the cancelation of cost-plus-fixed-fee contracts involves no possibilities of loss. The potential risks involved are two types: (1) That an appreciable amount of costs and fees will be disallowed and not reimbursed by the Government;

(2) That the company as custodian of Government-owned inventory may be held accountable for mistakes in procurement and for excesses and shortages in various items.

If the past Government approval of costs under cost-plus-fixed-fee contracts is used without question at the time of termination, the possibilities of the first type of loss would be no greater than those referred to under receivables. The risks would be greater, however, if changes in Government procedure and personnel or the pressure of public opinion in favor of Government economy caused a more rigid interpetation to be applied by the Government in reviewing the admissibility of expenditures and fees.

Likewise, the risks naturally will be greater if all expenditures under contracts being terminated are to be reexamined as to admissibility by the General Accounting Office or other agencies of the Government. In the latter event expenditures applicable to planes already delivered under these contracts as well as expenditures represented by inventories might be disallowed, and amounts for which the company had been previously reimbursed might be deducted from the final settlement.

The second major type of risk referred to above has to do with the final transferring to the Government of the inventory for which it has paid. Assuming that all costs charged by the companies to these inventories are allowable costs, question will still remain as to whether the physical inventory is in line with the amount the records show and whether the nature of that inventory is such that the company will be considered to have fulfilled its responsibilities as custodian. Whether or not this risk is serious depends upon the standards by which the companies' management of the inventory is judged. The wartime operating difficulties mentioned above affect the management of cost-plus-fixed-fee inventories just as they affect company-owned inventories.

There are, therefore, some risks inherent in the custodianship of this Government property entirely apart from the other risks connected with cost-plus-fixedfee receivables. For this reason certain statistical measures have been applied in this report to total inventories, including cost-plus-fixed-fee inventories. The magnitude of total inventories is such that none of the companies can afford to absorb any sizable loss on them.

MEETING IMMEDIATE LIABILITIES

Apart from possible losses in liquidation of total inventories and receivables, there are risks connected with the timing of that liquidation. Regardless of ultimate settlements, the pressures of immediate liabilities might endanger the companies at the time of contract cancelation. Below, the nature of liabilities as of today will be examined and the nature of the risks involved briefly commented

upon.

Present sources of working capital.

Analysis of the current position of the aircraft companies shows that most of the working capital currently employed by the companies has been furnished by the Government, i. e., a major portion of the current assets are offset by current liabilities payable to the Government. Thus, as shown in table 11 below, 67.6 percent of current assets of the average company is furnished by the Government. Of the remaining 32.4 percent, a total of 24.3 percent is furnished by other creditors and 8.1 percent by the company itself.

The Government provides working capital in two different ways:

(1) It makes advances and progress payments to the companies in connection with specific contracts. Basically these are simply loans from the Government, secured by provisions that the funds will be used only for expenditures made for specific contracts. In the case of progress payments the Government usually is given a lien on or title to a portion of the inventory.

(2) The Government defers until the following fiscal year income-tax liabilities and liabilities on certain refunds. In effect, the companies are allowed to use the relatively high profits before taxes and refunds of one year to finance themselves in the next year.

Actually the Government has been furnishing working capital to the average company in a third way which is not reflected on the conventional balance sheet, i. e., it furnishes capital through the use of cost-plus-fixed-fee contracts. Company receivables include the expenditures under cost-plus-fixed-fee contracts for which the company has not been reimbursed. They do not, however, include over $30,000,000 of inventories under such contracts for which the average company has already been reimbursed by the Government. If this $30,000,000 is taken into account, about 73 percent of working capital was, in effect, furnished by the Government.

TABLE 11.-Current liabilities and net working capital as a percentage of total current assets for airframe manufacturers: End of 1942 fiscal year

NOTE. At balance sheet date, the average company also had expended $62,900,000, which was represented by government-owned inventories under cost-plus-fixed-fee contracts. It is estimated that approximately $32,000,000 of the amount of these expenditures, included in receivables, are due from the government but not yet paid.

The remaining $30,900,000 of expenditures were not reflected on the balance sheet because the govern ment had already reimbursed the company for them.

22 Estimated. Exact figures are not available for all companies.

Timing of liquidation.

Unless the Government should demand payment for advances, taxes, and refunds before it is willing to make payments to liquidate receivables and inventories, the possibility of immediate difficulties in meeting existing current liabilities at the time of contract cancelation does not appear serious. It seems improbable, for example, that the Treasury will insist on payment of taxes before the Army makes payment on receivables and reimburses the companies for inventories.

The timing risks will be further decreased by the use of V-loans. Several of the companies have made V-loans and started to draw down funds thereunder in 1943. The Federal Reserve Board recently announced a broadening of the use of V-loans with specific reference to making working capital available at the time of contract cancelation. The use of these Government-guaranteed bank loans and their provisions will not be considered in detail in this report. It is relevant to this discussion, however, that the termination of these loans affords the companies substantial protection against the risks involved in slow liquidation of wartime inventories and receivables.

The companies using such loans, however, will be faced with the eventual necessity of paying off these loans with the funds obtained from liquidation, and any losses involved in these liquidations will reduce the companies' net working capital. In this respect the use of V-loans fails to protect the companies any more than do Government advances or other forms of credit.

The 1942 year-end balance sheet does, however, indicate some degree of risk with respect to the timing of the cash-flow. Chart 2 shows graphically that the average company's liquid funds (unrestricted cash and securities) were equal to only 78 percent of liabilities due to creditors other than the Government. These include trade creditors, banks, and employees. If Government action in liquidating receivables and inventories were delayed, the claims of these other creditors might create difficulties.

EXPENSES VERSUS WORKING CAPITAL

There is one further type of "liquidation" risk. The continuing out-flow of cash to suppliers, employees, and others could exhaust the companies' funds. This risk depends primarily upon the rapidity with which the Government decides to terminate war contracts. If these contracts are canceled suddenly, the companies could be embarrassed for cash. The magnitude of the cash out-flow is such, however, that the companies must depend in large part upon Government reimbursements in order to meet expenses during this period.

Table 12, page 21, shows the relationship of liquid funds (unrestricted cash and securities) to the monthly rate of expenses for wages, salaries, and materials in the first quarter of 1943. At the end of the 1942 fiscal year, the average company had sufficient liquid funds to meet these expenses for about 5 weeks (1.2 months). For all 11 companies, the range varied from a high of 13 weeks to a low of less than 1 week.

The extent of a temporary shortage of cash at the time of contract cancelation will depend on whether:

(1) Contracts are canceled gradually or precipitously;

(2) The companies can curtail employment and cancel orders for materials as rapidly as contracts are canceled;

(3) The Government liquidates receivables and inventories promptly.

The nature of the problem will thus depend primarily upon the timing of Government action. The present free cash of most companies would not permit them to meet immediate liabilities and finance pay rolls and materials purchases for any extended period of time.

Net working capital is even smaller than free cash in relation to current expenses. Five weeks' pay rolls alone or 2 weeks' pay rolls combined with expenses for materials would exhaust the present net working capital of the average company. For the 11 companies the range with respect to pay rolls alone would be a high of 7 weeks and a low of less than 1 day; with respect to pay rolls and materials together, the range is from 3 weeks to less than a day.

TABLE 12.—Relationship of liquid funds and net working capital to certain expense items for airframe manufacturers

Determination of the rate of curtailment of pay rolls involves major social as well as business problems. The airframe manufacturers do not at present have the capital to support more than a fraction of present pay rolls if war contracts are canceled. And the possibility of the firms being able to use most of their present labor force in peacetime operations is remote. The rate at which employment will decrease is, therefore, primarily dependent on Government action.

The settlement of outstanding commitments for materials at the time of contract cancelation also will be a complex problem for both the companies and the Government. Complete data are not available, but information from several companies indicates that such commitments varied from 9 to over 18 times the monthly average materials expenses.

Under present cancelation clauses, the Government directly or indirectly will assume the obligations arising from commitments with suppliers and subcontractors. The manufacturers, however, are expected to assume the initial responsibility for canceling purchase orders and making settlements with suppliers. Because of the vast numbers of such suppliers, the technical problems of arranging these settlements will be extremely complex and the companies may experience difficulties in carrying out their obligations under the terms of the contracts. If many months of accounting and negotiation both with the Government and with subcontractors should be required, the mere clerical and legal costs could result in a substantial further drain on working capital.

IV. ADEQUACY OF RESOURCES FOR CONVERSION

An examination of the specific resources and liabilities of aircraft companies has made it apparent that liquidation losses, particularly with respect to inventories, could impair the solvency of the industry if the termination of contracts is abrupt or if governmental contracting agencies interpret termination rules in a rigid manner. On the other hand, it is entirely possible that a carefully controlled tapering off of war orders in combination with a liberal treatment of the contractors' cancelation claims could leave the companies with their existing working capital virtually intact. The most probable development may well be midway between these extremes.

In any event, there will be certain other important costs of contraction and transition to peacetime operations which are not covered by claims the manufacturer will be able to present to the Government as allowable terinination charges. While the amount of these costs cannot be predetermined, they are sufficiently important to have a major bearing on the industry's financial position in relation to post-war requirements.

COST OF CONTRACTION

Contraction from an inflated wartime size to smaller-scale operations will involve many costs which cannot be charged to the Government under wartime contracts. The modified peacetime requirements both for physical plant and for personnel will necessitate expenses, the nature of which is reasonably predictable even if the amounts are not.

Only a proportion of the plant rearrangement expenses will be offset by specific claims against the Government. Some of the modifications in previous plant structure or internal rearrangements were made under war contracts which provide for specific restoration payments by the Government. Of probably greater importance, however, will be a general rearrangement including such items as materials, machinery, storerooms, receiving and inspection stations. Extensive changes of this type probably will be required for low-cost operations on a smaller scale.

While the costs of rearrangement of physical facilities are difficult to estimate in advance, the contraction of supervisory and executive personnel presents an even more intangible problem. The resulting indirect costs may be high in terms of confusion, mistakes, and low morale. There will inevitably be a difficult period during which functions are being rearranged and various responsibilities incident to special wartime requirements are being eliminated or reassigned. For instance, the large staffs now concerned with handling materials priorities or with the expediting of deliveries from subcontractors and suppliers contain many keymen who will have to be reabsorbed into the changed organization. Such problems will be costly in terms of inefficiency as well as in terms of temporary nonproductive salaries. No precise measure of these costs will be possible, however, through orthodox accounting procedures.

EXPENSES OF TRANSITION PERIOD

Although some substantial portion of the industry will probably continue war-plane production during peacetime, another portion of the industry will experience a transition period during which it will be out of war operation but not yet into peacetime production.

The engineering staffs of airframe manufacturers have been faced with the task of designing ever better war planes. There has been little time to develop completed blueprints for peacetime models. After the blueprint stage is past, the companies will still face many months of research, tooling, experimental production, and testing of trial models before real production can proceed. Such expenses, together with the outlay arising from the necessity of maintaining key factory and office personnel in partial idleness during this period, may run into millions of dollars for the individual companies.

Some measure of the magnitude of these costs can be obtained by noting that the development expense of the DC-4 (four-engine transport) by Douglas Aircraft Co. 23 before the war was reported at $2,059,520. This company, however, had a substantial volume of other business during this period to carry its overhead and factory personnel. Were the development of this ship to have taken place, as others must, during the interim period after the curtailment of war production, it would appear that the over-all expenses including overhead might have been much higher.

Selling and promotional expenses may also be sizable during the transition period, especially if the companies seek a wide market for private planes or large foreign sales. The development of a sales force and dealer organization would consume appreciable time and money, for none of the companies have such an organization at present.

Present tax laws give the companies some relief from the full effect of losses incurred. The ability of an individual firm of obtain a reduction of the previous year's taxes by a carry-back of the loss sustained will lessen the final effect upon the company's financial position. Whether these tax refunds, which fall due the year after that in which the losses occur, will be received in time to meet the most pressing need for liquid funds is, of course, subject to question. Each company will also receive a post-war refund of 10 percent of the tax paid on wartime excess profits. This refund for the average aircraft company amounted to $730,000 at the end of 1942. At that time, the company was expending $24,23 Company's 1938 annual report.