Dividend Policy: What It Is And How A Company Decides What To Distribute

Businesses research, innovate and expand to strive to earn profits. And when this profit is distributed among the company's shareholders, it becomes a dividend. . A dividend is a share of the company’s profits that may be given to shareholders if and when it is declared by the company’s board. However, to distribute the dividends among the shareholders, a well-thought-out policy is formulated, which is called the dividend policy.

The dividend policy includes decisions about how much dividend to pay, when to pay, and whether to pay it at all. This policy reflects the company’s approach to balancing its realised profits between reinvestment for potential growth and distribution among shareholders.

In this article, we will learn about dividend policy and what factors influence it. Understanding these factors helps investors assess a company’s financial position and management approach and evaluate whether the investment aligns with their objectives.

Table of contents

• Factors affecting dividend policies
• Contractual and legal restrictions

Factors affecting dividend policies

Here are some of the considerations companies may have when deciding whether to pay dividends.

Investment opportunities

Whether it is for expanding operations, launching new products, acquiring assets or entering new markets, every business needs capital to potentially grow. Hence, if there is a potentially profitable investment opportunity available, then a company might prefer to reinvest its earnings instead of distributing them as dividends to shareholders.

A business would typically not want to rely on external borrowings if it has its own earnings to fund the new projects. In such cases, the business management may decide to retain most of the realised returns to finance these projects. This helps businesses pursue new potential opportunities without increasing debt.

On the other hand, established companies may not have many new projects to invest in. These companies may generate relatively consistent profits, but do not need to reinvest a majority of these.

The expected volatility of future earnings

One of the factors that affects the dividend policy is the company’s stability or volatility. Companies with relatively stable business operations and more predictable earnings may be better positioned to consider regular dividend payouts. Such companies are also able to plan their cash flows with greater visibility.

However, companies with earnings that fluctuate due to market conditions, economic cycles or seasonal demand patterns may prefer a conservative dividend policy. In such cases, management might choose to retain a larger share of potential profits to build financial reserves that could be used during less favourable periods. This might help businesses maintain operations even when profits may decline.

Financial flexibility

In a financial context, flexibility means the ability to adapt to changing economic conditions and meet unexpected financial needs. Among other things, it involves maintaining sufficient liquidity and having access to funds when required. A company with high financial flexibility is generally better placed to manage its working capital needs, fund new investments, or meet debt obligations without undue external pressure.

When deciding on dividends, management typically assesses whether distributing profits could weaken the company’s liquidity position. A firm that pays out most of its earnings as dividends may face difficulties in funding future requirements or dealing with emergencies. Hence, maintaining financial flexibility is important to support business continuity.

Tax considerations

Tax laws impact both the company and shareholders, leading to further influence on how dividends are distributed and how much shareholders may receive. Corporate taxes affect a company’s dividend policy in both direct and indirect ways. These taxes reduce the amount of profit left after tax, which in turn lowers the money available for distribution among shareholders.

Additionally, the management may consider the broader tax environment—such as the relative tax treatment of dividends versus capital gains—while deciding on payout levels.

Floatation costs

Floatation costs refer to the expenses a company incurs when it raises capital through the issue of new shares or debentures. These costs include underwriting fees, legal charges, advertising and administrative expenses. High flotation costs may influence a company’s decision regarding dividend payouts.

When floatation costs are high, raising external capital becomes expensive. In such situations, companies might prefer to rely on retained earnings to fund new projects or meet future capital requirements. Consequently, the company might reduce or postpone dividend payments to conserve internal funds.

Read Also: Dividends Guide: Key Types & Significance for Investors

Contractual and legal restrictions

There are also some legal rules that companies must follow when paying dividends. A company can only pay dividends out of its profits and not in a way that reduces its capital. These rules are meant to protect the interests of creditors and ensure the company maintains a sound financial position.

Before paying dividends, it’s also mandatory for a company to set aside money for depreciation, which means accounting for the decrease in value of fixed assets over time. Depreciation must be provided as per Schedule II of the Companies Act, 2013, before declaring dividends. This is important because it ensures that profits are calculated after considering asset wear and tear, helping the company maintain financial discipline for the future.

Read Also: What is dividend payout ratio?

Conclusion

Dividend policy is not simply about distributing profits but also about balancing the company’s growth plans, maintaining adequate liquidity, and ensuring compliance with financial and legal obligations. The factors affecting dividend policy include growth opportunities, earnings stability, financial flexibility, taxation, flotation costs and applicable legal requirements.

FAQs

What investment opportunities influence a company’s dividend policy?

When a company identifies profitable projects that indicate potential growth, it may retain earnings to finance those projects instead of distributing dividends.

How does the expected volatility of future earnings affect dividend decisions?

When a company expects its future earnings to fluctuate, it might prefer to maintain a conservative dividend policy. Retaining a portion of profits helps build reserves for less favourable periods.

What role does financial flexibility play in shaping dividend policy?

Financial flexibility allows a company to respond quickly to changing economic conditions. Firms that maintain liquidity reserves may be able to manage unexpected expenses or capital requirements. If a company prioritises financial flexibility, it might retain earnings to maintain relative stability, which might affect the size and frequency of dividend payouts.

How do tax considerations impact a company’s payout strategy?

These taxes reduce the amount of profit left after tax, which in turn lowers the money available for shareholders. Companies may consider the overall tax environment—including corporate tax and investor dividend tax treatment––before deciding on the dividend strategy.

What influence do floatation costs have on a dividend policy?

High floatation costs make it expensive for companies to raise capital through new issues. To avoid these expenses, companies might retain a larger portion of earnings to finance future projects internally. This might result in lower dividend payouts.