Corporate Accounting

Factors determining dividend policy of a company

Dividend Policy

Dividend policy is one of the most significant aspects that attract investors to a firm. It is the decision regarding, out of available earnings, how much profits will be retained and how much will be distributed among shareholders for their investments and the risk they incur.

Shareholders usually want dividends, but it is not prudent to distribute all possible earnings considering the unpredictable future and market volatilities.

Different companies pay dividends following own policies, and some companies do not pay dividends at all. For example, Microsoft (MSFT). This article discusses some of the very common dividend policies companies consider before declaring or paying dividends.

Factors determining the dividend policy

There are several factors that could be applicable in individuality or in a combination of two or more factors that decide the dividend policy of a company. Let’s have a quick look at them in the following paragraphs:

Liquidity

For paying the dividend, a firm will require access to funds. Even extremely prosperous firms can occasionally have difficulties in paying dividends if the resources are locked up in other types of assets. In summary, firms with higher liquidity pay dividends more frequently than companies with cash locked up in fixed assets or inventory.

Repayment of Debt

Companies having a high load of interest-bearing debts may be hesitant to pay dividends. Dividend payout may be made difficult if the debt is due for repayment. Because paying interest on interest-bearing assets is a necessity in virtually all nations. Shareholders acquire whatever remains after discharging liabilities of debt-holders. It is also conceivable that the firm is not left with any distributable earnings after paying interest on loans.

So, such firms would wait until an acceptable level of debt is cleared before they start paying dividends to shareholders. Preference share dividends may be an exception to this idea because their payout is viewed like interest-bearing debt.

Stability of Profits

As there are certain limitations on cash and loan credit given to the company, it has to earn revenue. To earn money for the shareholders, a company has to generate an income from sales or other means. At this point in time, the earning capacity of the company is known, and it can be predicted. This earning capacity is reflected in the company’s earnings and profits. It indicates how much of the total sales and profits of the company a company can generate from its operations.

In the event that earnings fall, the dividend policy will be lowered accordingly.

Control

The utilisation of retained earnings to finance a new project maintains the company’s ownership and control. This can be useful in businesses where the existing disposition of ownership is of relevance.

Legal Considerations

The legal rules put out parameters within which a business can declare dividends. It is done to safeguard the interest of creditors, lenders and other persons having a stake in the firm. The court or company law boards can regulate whether or how the firm can pay much dividend under consideration.

Risks in the Market

As there is always a risk in the market, the dividend policy of a company is determined in accordance with this risk. In the stock market, there are fluctuations. A company has to face this risk while making the decision on the dividend policy.

A company has to make a decision regarding the dividend policy by taking into consideration the various risks. If the company is making a decision without this risk in mind, it is a bad decision.

Inflation

Inflation must be taken into account when a firm establishes its dividend policy. This effect has been discussed in models of the dividend.

Expectations of the Management

The dividend policy is also affected by the expectations of the management of a company. In case the management is confident about the earnings of the company, the dividend policy is high. In the same way, in case the management is not confident about the earning ability of the company, the dividend policy is lowered.

Other Factors

Tax considerations and other variables such as dividend policies followed by other companies similarly positioned in the sector, management stance on dilution of existing control over the shares, fear of being branded as inept or inefficient, and cautious policy versus non-aggressive one.

Show More

Leave a Reply

Related Articles

Back to top button