What is Dividend Policy?
Dividend policy refers to the profit distribution technique employed by companies for distributing dividend among their group of shareholders. This policy determines the amount of dividend that need to be paid out by companies to their shareholders and with what frequency. Dividend policy is framed out by company’s board of directors and serve like a guideline for paying dividend among investors. Every company need to make decision on amount of profit generated by it.
The decision can be either to distribute money as dividends or retain it for reinvesting back into business enterprise. All such decisions are dictated by dividend policy of company, it is the only one used for structuring dividend related payments. It is termed as most crucial and integral element of corporate strategy for every company as demonstrate their financial health and influences the confidence of investors.
Dividend is money that is regularly paid by business among its shareholders out of profits, cash reserves and even debt. It is basically paid on per share basis either at every quarter, at end of six months or annually. The dividend payments are considered as reward for investors who inject their money into business and help them in growing their scale of operations. Therefore, it is must for all companies to effectively make strategies on dividend payments, so as to attract and engage investors for long-term.
Types of Dividend Policy
There are broadly five types of dividend policies utilized by public-listed companies, each of them is discussed in detail as given below: –
- Residual Dividend Policy: Residual dividend policy is a type of dividend distribution where dividends are paid by company on the basis of left-over earnings. Once company fulfils all of its planned investments then only takes decision to pay dividend. The shareholders receive amount that is left after company put aside funds for capital expenditures, working capital and other investments. Residual dividend policy is considered as most sustainable and logical policy under which company pays out dividend only when it can afford it to pay.
- Regular Dividend Policy: It is policy under which dividend payments are made at usual rate by company to its shareholders. Company generally fixes a certain percentage of dividend on company’s profit that is paid on regular basis. The amount of dividend payments will automatically be high, when profit earned is high. But it will be low in case if profit amount generated by company is low. Such dividend policy is more preferred by group of peoples who seek regular and consistent flow of income such as middle-class families, retired persons etc. Regular dividend is considered as most suitable policy for paying dividend and earning goodwill in eyes of experts.
- Irregular Dividend Policy: Irregular dividend policy is a type of dividend payment where dividends are not paid regularly by business and is solely dependent upon company’s own decision. The shareholders will get dividend payments only when company decides to pay them. Irregularities in payment of dividend arises of multiple reasons like short of liquidity, company priorities and volatilities in future earnings. Suppose if business has any new project to fund then instead of paying out dividends, it will give priority to retaining the profit amount. Investor in companies following this policy, are never sure about whether they will get any dividend amount or not during the year, or what amount will be paid to them as dividend.
- Stable Dividend Policy: Stable dividend policy is one where investors get fixed amount of dividend irrespective of volatility in company earnings. The shareholders will continue receiving the same dividend pay even if company incurs losses. Stable dividend policies do not form their basis over performance of company in short-term, but are more closely concerned with long-term prospect and forecasts. This policy offers investors the benefit of getting reliable and consistent pay-outs, even if in case company suffers short-term turmoil. However, for business enterprises, stable dividend policy may be a risky investment as profit level always fluctuates from time to time but they are required to pay fixed dividend irrespective of their earnings.
- No Dividend Policy: No dividend policy is option available to companies of not distributing any amount out of profit earned to its shareholders. The whole profit earned by business is retained and invested back into it, for funding attractive future growth opportunities or for supporting liquidity during unfavourable working capital season. It is more generally followed by growth-oriented companies. The companies without dividend policy are more likely to grow and expand at rapid rate, and also the value of their stock has high chances of appreciating significantly. However, this dividend policy discourages investors looking for sustainable income in long term.
Importance of Dividend Policy
- Signals company’s performance: A company’s dividend policy can signal to investors the company’s current and future financial performance. For example, a company that consistently increases its dividend payments is likely to be financially stable and growing, whereas a company that cuts or eliminates dividends may be struggling financially.
- Attracts investors: A company with a consistent and attractive dividend policy can attract a diverse group of investors, such as income investors who prioritize regular dividends and growth investors who focus on the company’s future growth prospects.
- Increases shareholder value: A dividend policy that is well-designed and executed can increase the value of a company’s shares by providing a steady stream of income to shareholders and by signaling to the market that the company is financially sound and committed to returning value to shareholders.
- Influences the cost of capital: The dividend policy can also affect a company’s cost of capital by influencing the cost of equity and the cost of debt. A company with a strong dividend policy is likely to have a lower cost of equity as it signals to investors that the company is financially stable and committed to returning value to shareholders.
- Provides flexibility: A company’s dividend policy provides flexibility in terms of how much it can pay out in dividends and when it can pay them. This allows a company to adjust its dividend payments based on its financial performance and future growth prospects.
- Enhancing reputation: A consistent and attractive dividend policy can help to enhance a company’s reputation among investors, which in turn can lead to a more stable share price and improved access to capital.
A well-designed and executed dividend policy can be a powerful tool for a company to signal its financial performance, attract investors, and increase shareholder value. It is important for a company to regularly review and adjust its dividend policy as necessary to align with its financial and strategic goals.
Factors Affecting Dividend Policy
The dividend decision of business is affected by variety of reasons that are discussed in details as given in points below: –
- Financial needs of company: The financial needs of company majorly influence its decision of paying out dividend among its shareholders. If company has strong investment opportunities available to it, then profit earned will be retained instead of distributing in the form of dividend. However, if there are no projects available to company for doing any investment then shareholders will get dividend payments out of profit earned.
- Profitability: Profitability of business enterprise serve as key factor in deciding decisions related to payment of dividends. The dividends are paid from profits earned by company, if there is no profit then companies won’t be able to pay any dividend. Company’s profitability is reflected in net profit ratio and ratio of profit to total assets. Therefore, companies generating high level of profits will be able to pay higher dividends as compared to one making less profits who will adopt conservative policy on dividend.
- Expectations of shareholders: The expectations of shareholders, whether they want steady income or capital appreciation on their shares value is considered by company while taking dividend related decisions. If company believes that its shareholders are small investor looking for steady income, then it should maintain stable dividend payments. On the other hand, if company investors are large financial institutions looking for appreciation on their share value, then it may limit pay out amount and reinvest profit back into business for capital appreciation motive.
- Maintaince of reserves: All business organizations need to maintain distinct types of reserves in order to facilitate efficiency running of their operations. Reserves are maintained for meeting expenses related to -depreciation, bad debts, dividend equalization, preference share redemption, debenture redemption, working capital, taxation, expansion and many more. The amount found surplus of these reserve is available for distributing as dividend among group of shareholders. Therefore, more the amount of reserve is maintained company than less will be dividend pay-out.
- Liquidity: The dividend decisions are affected to greater extend by liquidity of funds. Company’s cash position is big criteria in deciding strategies related to distribution of dividend. The cash is needed for meeting different contingencies that cannot be ignored for ensuring continuity of operations. Manytimes, company earns high amount of profit but majority of it get blocked into working capital or it may acquire assets. Therefore, in such cases, its overall liquidity will be poor resulting in pay out of lower amount dividend. Company can pay higher dividend only if company has good amount of earning along with sound liquidity position.
- Government taxation policy: The taxation policy of government affects either directly or indirectly the dividend policy of company. In present days, large amount of taxes is levied by government for adding funds into its treasury. The amount of tax reduces residual earnings after tax available for shareholders. This thing put management team into difficult situation where they are unable to maintain stable or high rate of dividend. Therefore, taxation policy is largely taken into consideration at the time of dividend policy formulation.
- Legal requirements: There are certain legal restrictions prescribed by Indian companies Act 1956, that need to be considered by board of directors while declaring dividend. Payment of dividend is found to be legal only if it does not reduce amount of company’s capital post payment. Such rules are in place for safeguarding the interest of creditors. Also, it is important to provide depreciation before making any dividend payment. Depreciation providance is crucial because it helps companies in retaining amount of profit for replacing fixed assets in future.
- Inflation: Rate of inflation compels business organization in retaining major part of their profit and distributing lower amount of dividend. Companies carrying out their operations in environment of high inflation, requires more financial resources for their survival. With rise in prices, the amount of capital reserve meant for fixed assets purchase also need to be increased by companies. Therefore, in presence of inflationary environment, companies can’t afford to provide higher dividend and will stick to lower dividend pay-out.