A dividend policy is a strategy that a company uses to decide how much money it will give out as a dividend.
It can be important for a company to have a diverse set of dividends so that the corporation’s shareholders are not allocating the same percentage of their income to different investments. A dividend policy also helps ensure that taxable distributions are distributed at the correct rate to shareholders.
The main reason for having a high dividend policy is that the company’s dividend payment policy to the investors encourages them to remain with the company and not withdraw their money. This is the main reason for maintaining a high dividend policy so that the company can attract investors and continue its business operations.
Different companies pay dividends according to their own policies, and some companies do not pay dividends at all. For example, Microsoft (MSFT). This article discusses some of the widespread dividend policies companies consider before declaring or paying dividends.
Relationship between Dividend Policy and Dividend Payout Ratio
Dividend policy refers to the determination and direction of dividend payout ratio by the company as a policy to its shareholders. It is one of the key factors that determine the future growth potential of a company.
In simple words, it is a function of the company’s growth rate and capital spending. If the company has a high growth rate and a high growth spending ratio, it is expected to have high growth and low dividend payout ratio. The dividend payout ratio is also referred to as the dividend payout ratio, dividend per share, dividend payout, and dividend payout ratio. This ratio is expressed in terms of percentage.
A high dividend payout ratio indicates higher growth as it allows the company to have more capital available to grow and invest in the future growth of the company. On the other hand, a low dividend payout ratio indicates lower growth of the company as the same amount of capital is not allowed for future investment. The dividend payout ratio is the total dividends as a percentage of the share capital.
Factors determining the dividend policy
Several factors could be applicable in individuality or in a combination of two or more factors that decide a company’s dividend policy. Let’s have a quick look at them in the following paragraphs:
Liquidity is one of the most significant factors that impact the dividend policy of a company. 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 with high 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 certain cash and loan credit are limited to the company, it has to earn revenue. A company has to generate an income from sales or some other means to earn money for its shareholders. At this point in time, the company’s earning capacity 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 can be generated from its operations. In the event that earnings fall, the dividend policy will be lowered accordingly.
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 ownership disposition is relevant. In such cases, the company would want to retain more profits rather than distribute it among its shareholders.
The legal rules set out parameters within which a business can declare dividends. It is done to safeguard the interests of creditors, lenders, and other parties having a stake in the firm. The court or company law boards can regulate whether or how much the firm can pay dividends.
The payment of dividends is generally restricted by law to prevent companies from paying out too much cash and running into financial trouble. For public companies, the law generally limits dividend payments to the net income earned in the previous year, with some exceptions for companies with a strong financial position.
Private companies may have more flexibility in terms of how much they can pay out in dividends, but they still need to be mindful of their overall financial condition. A company that pays out too much in dividends may find itself struggling to meet its obligations in the future.
Risks in the Market
As there is always a risk in the market, a company’s dividend policy is determined by this risk. In the stock market, there are fluctuations. A company has to face this risk while deciding on the dividend policy.
A company has to decide on the dividend policy by considering the various risks. If the company is deciding without this risk in mind, it is a bad decision. Sometimes the company might need a good cover of profits to survive with the market conditions. Retained earnings can be the best source of survival in such times.
If the company doesn’t have enough cash flow to cover its operating costs and dividends, it will have to cut or eliminate the dividend. Inflation can also be a factor in determining a company’s dividend policy. A company that expects high levels of inflation in the future may choose to increase its dividend to protect the purchasing power of its shareholders’ investment. However, if a company anticipates that inflation will erode its profits, it may choose to reduce or even suspend its dividend payment. 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 a company’s management. The dividend policy is high if the management is confident about the company’s earnings. In the same way, if the management is not confident about the earning ability of the company, the dividend policy is lowered.
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.
To sum up, dividend policy is crucial as the investors invest in the company in the hope of earning profits in the form of dividends. However, the internal management has to see investors’ expectations as well as the internal conditions of the company. Based on several factors mentioned and described above they form their dividend policy.