When a company increases its earnings and makes a profit, the board of directors may vote to keep some of it as retained earnings and distribute some of it as cash dividends to stockholders. The distribution of dividends is based on pro rata, meaning stockholders receive dividends in proportion to their ownership in the company. For instance, if an investor owns 2 percent of the common shares, she receives 2 percent of the dividend. Boards of directors must account for several factors before declaring a dividend.
Company boards may decide to pay dividends from retained earnings, which is legal in all states. Conversely, many states prohibit dividends payment from the company’s legal capital. Nevertheless, it is legal to pay dividends from the excess of par in some states. In other words, a company may decide to pay dividends from the additional funds it has received above the par value -- value per share assigned in the corporate charter. Some loan agreements may constrain a company to pay dividends from the retained earnings only.
A company should consider not depleting its total retained earnings when paying dividends. This may jeopardize its ability to continue to pay a dividend in the next period unless it generates a net positive income. Boards of directors may decide on the amount of dividend payments. However, directors may decide not pay it due to the company’s financial obligations to creditors. Nevertheless, dividends do no accrue any interest in contrast with other liabilities like loans. In other words, not paying creditors may cause risk to the company’s survival. However, not paying dividends to stockholders does not have any financial ramifications.
Timing and Amount of Dividends
Board of directors should pay close attention to the company’s liquidity before declaring and paying any dividends. Moreover, when a dividend payment is withdrawn, stockholders may express their dissatisfaction by selling the shares, which may cause the stock price to fall. As a result, sometimes a company may decide to pay stock dividends to keep its investors content. On the other hand, if a company decides to pay cash dividends or increase its payment while its debt rises, investors may see this as a warning signal. Furthermore, any increase in dividend payments in conjunction with irregular income may also send a negative signal to the investors. Thus, a board of directors should consider the serious consequences of reducing a dividend or canceling the payment altogether.
If a company generates enough cash to justify possible cash dividends, the board of directors is expected to declare and pay dividends. Otherwise, the stockholders may pressure the company to do so. Investors expect a company to utilize the earnings to grow and expand the operation. However, in the absence of any expansion plans or capital investments, investors do not appreciate the excessive cash holdings in the company. On the other hand, they support a growth-oriented company’s decision to conserve cash for the future expansion due to the possible asset appreciation and higher stock price objectives.
- “Financial Accounting: Tools For Business Decision Making”; Paul D. Kimmel, et al.; 2009
Dr. Ned Gandevani holds his Master of Business Administration and Ph.D. degrees in finance. He has authored four published books in investment and trading topics and has written for "Technical Analysis of Stocks and Commodity," "Futures" and "Stocks, Futures and Options (SFO)" magazines. Dr. Gandevani currently teaches finance and MBA courses at several universities in the U.S.