Constraints on Paying Dividends

Most companies recognize that the shareholders have a desire to• receive dividends, although some of the shareholders are also interested in the capital gains. But the company’s decision regarding the amount of earnings to be distributed as dividends depends on a number of factors. The factors, which restrict the firm’s ability to declare and pay dividends, are below:

Legal Restrictions

The dividend policy of the firm has to be evolved within the legal framework and restrictions. The directors are not legally compelled to declare dividends. For example, the Companies Act provides that dividend shall be declared or paid only out of the current profits or past profits after providing for depreciation. However, the Central Government is empowered to allow any company to pay dividend for any financial year out of the profits of the company without providing for depreciation. The Central Government shall give such relief only when it is in the public interest. The dividend should be ~d in cash, but a company is not prohibited to capitalize profits or reserves (retained earnings) for the purpose of issuing fully paid bonus shares (stock dividend). It has been held in some legal cases (for example, Lubbock v. The British Bank of South America) that capital profits should not be distributed as dividends unless the distribution is permitted by the company’s Articles of Association and the profits have been actually realized.

The legal rules act as boundaries within which a company can operate in terms of paying dividends. Acting within these boundaries a company will have to consider many financial variables and constraints in deciding the amount of earnings to be distributed as dividends.

Liquidity

The payment of dividends means cash outflow. Although a firm may have adequate earnings to declare dividend, it may not have sufficient cash to pay the dividends. Thus, the cash position of the firm is an important consideration in paying dividends; the greater the cash position and overall liquidity of a company, the greater its ability to pay dividends. A mature company is generally liquid and is able to pay large amount of dividends. Such a company does not have much investment opportunities, nor are the funds tied up in permanent working capital and, therefore, has a sound cash position. On the other hand, a growing firm faces the problem of liquidity. Even though it makes good profits it needs funds for its expanding activities and permanent working capital. Because of the insufficient cash or pressures on liquidity in case of a growth firm, management may not be able to declare dividends.

Financial Condition

The financial condition or capability of a firm depends on its use of borrowings and interest charges payable. A high degree of financial leverage makes a company quite vulnerable to changes in earnings and also, it becomes quite difficult to raise funds externally for financing its growth. A highly levered firm is, therefore, expected to retain more to strengthen its equity base. However, a company with steadily growing earnings and cash flows may follow a high dividend payment policy in spite of high amount of debt in its capital structure.

Access to the Capital Market

A company, it not sufficiently liquid, can pay dividends if it is able to raise debt or equity in the capital m8rkets. If it is well established and has a record of profitability it will not find much difficulty in raising funds in the capital markets. Easy accessibility to the capital markets provides flexibility to the management in paying dividends as well as in meeting the corporate obligations. Thus, at last growing firm, which has a tight liquidity position, will not face any difficulty in paying dividends if it has access to the capital markets. A company which does not have sound cash position and is also unable to raise funds, will not be able to pay dividends. Thus, greater the ability of the firm to raise funds in the capital markets, the greater will be its ability to pay dividends even if it is not liquid.

Restriction in Lone Agreements

Lenders may generally put restrictions on dividend payments to protect their interests when the firm is experiencing liquidity or profitability difficulties. As such the firm agrees as part of a contract with a lender to restrict dividend payments. As an example, a loan agreement may prohibit payment of dividends as long as the firm’s debt-equity ratio is in excess of 1.5 : 1 or when the liquidity ratio is less than 2 : I or may require the firm to pay dividends only when some amount of current earnings has been transferred to a sinking fund established to retire debt

These are some of the examples of the restrictions put by lenders on the payment of dividends. When these restrictions are put, the company is forced to retain earnings and have a low payout.

Control

The objective of maintaining control over the company by the existing management group or the body of shareholders can be an important variable in influencing the company’s dividend policy. When a company pays large dividends, its cash position is affected. As a result, the company will have to issue new shares to raise funds to finance its investment programmers.

The control of the existing shareholders will be diluted if they do not want or cannot buy additional shares. Under this circumstance, the payment of dividends may be withheld and earnings may be retained to finance the firm’s investment opportunities.

Investment Opportunities

We have ‘discussed earlier that a dividend policy is greatly influenced by the financial needs of the company. A growing firm gives precedence to the retention of earnings over the payment of dividends in order to finance its expanding activities. When investment opportunities occur infrequently, the company may not be justified in retaining the earnings at least during those periods when such opportunities do not exist. If the company retains earnings during such periods, the retained funds would either be reinvested in short-term securities yielding nominal returns or remain idle. This will have an impact of reducing the wealth of shareholders. The better course,’ when the investment opportunities arise infrequently, is to follow policy of paying dividends and raise external funds when the investment opportunities occur.

Inflation

In an indirect way inflation can act as a constraint on paying dividends. Our accounting system is based on historical costs. Depreciation is charged on the basis of original ,costs at which assets were acquired. As a result, when prices rise, funds saved on account of depreciation would not be adequate to replace assets or to maintain the capital intact. Consequently, to maintain the capital intact and preserve the earnings power of the firm earnings would be retained.