The net profit earned by a company after taxes belongs to shareholders. This dos not mean that the whole profit will be distributed among the shareholders. It is the prime responsibility of the management to determine what part of earnings should be retained and what should be distributed. In deciding about the distribution of profit, the management has to concentrate on the following issues:
- Ploughing back of profits.
- Retained earnings.
Ploughing Back of Profits
Ploughing back of profit is an important means of conservation of profits, for it means reinvestment of retained earning in the business, and becomes an important source of internal financing. In fact, profitable enterprise not only in India but abroad as well, use profit to finance their expansion and development programme.
They find it desirable to plough back profits to finance their various activities rather than to distribute them in the form of dividend and then raise capital from other sources. This method of financing can be effectively employed for the expansion of business. In other words, it is an ideal arrangement from the point of view of corporate management. In deciding upon ploughing back profits, the management has to decide how much of the profits has to be retained in the business and how much is to be paid out to the stockholders in the form of dividends.
As a rule, there is an inverse relationship between the dividend paid and profit retained with the company for the purpose of ploughing it back. Therefore, if a higher dividend is paid, the quantum of profit retained for reinvestment will be small. The management must strike a fair balance between these two decisions to ensure that the shareholders’ requirements for a steady dividend remain satisfied and that the continuous flow of business is not interrupted for lack of funds.
The process of ploughing back of earnings into business instead of distributing them in the form of dividend has proved to be so advantageous that some authorities on finance consider it desirable to distribute only half of the profit to stockholders. Such a policy certainly contributes to the financial strength of an enterprise. But it may lead to unnecessary accumulation of capital if the company does not expand the area of its operations.
One of the crucial decisions pertaining to the distribution of earnings relates to the various aspects of dividends. The policies relating to dividends affect the overall financial structure of a firm, for various issues, such as the retention of earnings, reserves and surplus, ploughing back of profits, profit planning, etc., are monitored by such policies.
Dividend earnings are a reward which shareholders get for providing venture capital. This reward may include, besides the normal interest rate, something more to absorb the risk assumed by stockholders.
In the case of a proprietary organization, such as a sole trading company or a partnership, proprietors can get their dues from the organization by securing payments out of the capital or from available profits. Here, the rationale of profit distribution largely arises out of their personal interest. In sharp contrast to this, the impersonal nature of corporations, arising from the divorce of ownership from the management, calls for a fresh look at the problem of profit distribution.
The problem is twofold. First, it is the prime responsibility of the management to satisfy the
shareholders by offering them a fair return on their investment; second, it has to ensure that the financial health of the company is safeguarded even by withholding the dividend, if necessary.
The term dividend policy refers to the consistent approach to the retention-versus-distribution decision rather than a decision made on a purely ad hoc basis from time to time. A dividend policy embodies in itself decisions pertaining to when and how much dividend is required to be paid.
The formulation of a dividend policy is a crucial and an extremely difficult decision because of the conflicting nature of objectives, and the absence of adequate measures for the computation of an optimal policy. In such circumstances, the dividend policy tends to be intuitive. Therefore, to make it scientific, it is desirable that undertakings base it on business tenets as well as on legal foundations. In deciding about dividends, managers are expected to take policy decisions pertaining to:
(a) The optimum amount of dividend to be paid;
(b) Varying dividend level; and
(c) Varying Dividend Payout.
It is in the interest of both corporations and shareholders that the dividend rate established should be maintained as far as possible. If the ploughback of profits yields heavy returns in the form of dividends and capital appreciation, the enlightened shareholders will feel contented. Contrary to this, if dividend limitations are such that the rate of dividend is permanently pegged down at a low figure, prospects of procuring capital will be seriously jeopardized.
Therefore, in deciding about the dividend policy, the following factors should be given due
- The relation of dividends to earnings;
- Contractual and legal considerations;
- Alternative reinvestment;
- Availability of external capital;
- Relative cost of external funds;
- Considerations of business cycles;
- Future capital requirements;
- Past dividend policy and stockholder’s relationships;
- Stability of dividends;
- Target payout ratio;
- Ability to pay for services.
Besides these factors, a sound dividend policy is contingent upon:
(a) the accuracy with which the firm’s income has been estimated;
(b) the accuracy and reliability of the profit forecast;
(c) the accuracy with which future financial requirements have been assessed.
It should be borne in mind that if the dividend paid out of net income is based on highly subjective factors, it is likely to be questioned more than if it is based on clear-cut data. In a firm, if both profit levels and growth rates are relatively equal, the directors have a logical base for formulating dividend policies.
The net profit of the company is generally shown in the surplus account and is more aptly termed as “earnings retained in the business”. It is not desirable on the part of companies to pay dividend out of retained earnings and create a capital deficit. Practically all foresighted managements prefer to show more reserves than the amount paid on dividend account in the current financial year. It is always preferable to have large retained earnings because any operating loss or excess of dividend can be charged against this account without affecting the original capital.
Retained earnings are mostly tied up in the form of buildings, inventories, etc., whereas dividends are required to be paid in the form of cash; Therefore, the management, besides maintaining an adequate reserve, should keep adequate cash to disburse dividends.