Analysis of Financial Statements_17

Dividend Policy

Introduction

• The important aspect of dividend policy is to determine the amount of earnings to be distributed to shareholders and the amount to be retained in the firm

• Retained earnings are the most significant internal sources of financing the growth of the firm.

• On the other hand, dividends may be considered desirable from the shareholders’ point of view as they tend to increase their current return

• Payout Ratio-which is dividend as a percentage of earnings-is an important aspect of vis-à-vis the dividend policy.

• 100 percent minus payout percentage is called retention ratio.

• Growth=ROE X Retention Ratio

Practical Consideration in Paying Dividends

• Financial Need of company.

• Shareholders Expectations.

• Closely / Widely Held Company.

• - Closely Held Cos. are those where the shareholder base is small and homogenous and the needs of the shareholders are known very well by the management.

• - Widely Held Cos. are those where the shareholder base is large and heterogeneous and it is difficult to satisfy each shareholders needs as they differ due to the large base. Hence in this case it is advisable to satisfy the needs of the major shareholders, but the needs of the other shareholders should also be taken into account

Constraints on Paying Dividends

• Legal Restrictions: The co. is bound by certain legal restrictions within which they should abide.

• Liquidity: Although a firm may have adequate earnings to declare dividend, it may not have sufficient cash to pay dividends. Thus, the cash position of the firm is an important consideration in paying dividends; the greater the cash position and overall liquidity of a company, the greater will be its ability to pay dividends.

• Borrowing Capacity: A high degree of financial leverage makes a company quite vulnerable to changes in earnings, and also it becomes quite difficult to raise funds externally for financing its growth

– Access to the Capital Markets: A company that is not sufficiently liquid can still pay dividends if it is able to raise debt or equity in the capital markets. If it is well established and has a record of profitability, it will not find much difficulty in raising funds in the capital markets.

– Restrictions in Loan Agreements: Lenders may generally put restrictions on dividend payments to protect their interests when the firm is experiencing low liquidity or low profitability.

– Inflation: Our accounting system is based on historical costs. Depreciation is charged on the basis of original costs at which assets were acquired. As a result, when prices rise, funds equal to depreciation kept aside would not be adequate to replace assets or to maintain the capital intact

Stability of Dividends

• Constant Dividend per Share or Dividend Rate: Fixed amount per share or a fixed rate on paid-up capital as dividend per year

• Constant Payout: Paying a fixed percentage of net earnings every year.

• Constant Dividend per Share Plus Extra Dividend: The small amount of dividend per share is fixed to reduce the possibility of ever missing a dividend payment. By paying an extra dividend in periods of prosperity, an attempt is made to prevent investors from expecting that the dividend represents an increase in the established dividend amount.

Significance of Stability of Dividends

• Resolutions of investors uncertainty.

• Investors’ desire for current income.

• Institutional Investors’ Requirement.

• Raising Additional Finances.

Forms of Dividends

• Cash Dividends

• Bonus Shares (Stock Dividend).