What is Dividend Policy?

Long-term investments in any company require in-depth research of various aspects. Among these is the company’s dividend policy, which determines the amount and the frequency of dividend payouts. Not sure what the meaning of a dividend policy is and why it’s important? In this article, we’ll answer these questions and more, so you can better decode a company’s dividend payout structure before you invest in its shares. 

Dividend Policy Meaning

A dividend policy is a strategy followed by a company to determine how its profits will be distributed among its shareholders. This constitutes dividends, which are essentially parts of a company’s profits that are paid out to shareholders instead of being reinvested in the company. A dividend policy helps determine how much of the profits, if any, will be distributed as dividends. It may also dictate the frequency of dividend payments. 

For investors, the dividend policy is crucial because it gives insights into potential returns. If you want to invest in a company over the long term, you need to know the finer details of its dividend policy, so you can anticipate cash flows better and formulate your investment strategy more smartly. 

Also Read More About What is Dividend Investing?

Dividend Policy Example

Now that you have seen what the meaning of a dividend policy is, let us discuss an example of a dividend policy. Say a company earns profits of ₹50,00,000 in a financial year and, as per its dividend policy, decides to distribute 30% of these profits as dividends. This means the total dividend paid out will be ₹15,00,000. Now, suppose the company has 5,00,000 outstanding shares. In that case, the total dividend payout, as per the company’s dividend policy, will be ₹3 per share. 

The remaining profits, i.e. ₹35,00,000 will be reinvested in the company and used to fund its growth, expansion ventures, product development, R&D and other such endeavours that can further growth. 

Types of Dividend Policy

Depending on the particulars involved, the dividend policy of a company may be classified as any of the following: 

• Fixed Dividend Policy

As per this policy, the company will pay the same amount of dividend per share each year. This amount remains unchanged, no matter whether or not the entity earns profits and no matter how high or low such profits may be. For instance, a company with a fixed or stable dividend policy may decide to offer a dividend of ₹2 per share annually. 

• Constant Dividend Policy

The meaning of a dividend policy that is constant implies that the company pays out dividends at a specific percentage of its earnings. For instance, say a company’s policy requires it to pay 10% of its earnings as dividends. Then, if the company earns ₹10 crore in a year, it is required to pay ₹1 crore as dividends. 

With this type of dividend policy, the higher the earnings, the higher the dividends. Conversely, if a company earns less during a financial year, the dividends paid out will also reduce proportionately. 

• Residual Dividend Policy

In a residual dividend policy, the company prioritises its investments, expenses and other growth-related or operational costs. If any profit remains after these requirements have been met, it is distributed as a dividend to shareholders. So, the amount of dividends paid each year is variable. In some years, the company may not pay any dividends either. 

Know More About Types of Dividends

Factors Affecting the Dividend Policy

Before investing in a dividend-paying company, you must be aware of the following factors affecting the dividend policy of the entity. 

• Profitability

A company’s profitability is a crucial factor affecting its dividend policy. Higher profits generally allow for larger dividends because companies may have surplus funds to distribute among shareholders. Conversely, low or inconsistent profits may be reinvested in the business. 

• Cash Flow

Strong cash flows are also essential for paying dividends. A company may be profitable on paper, but if its cash flows are insufficient, it may be unable to pay dividends regularly. So, the liquidity and cash flow levels of a business also directly affect its dividend policy and how much of its profits can be distributed to its shareholders. 

• Debt Levels

The debt levels of a company also impact its dividend policy significantly. High debt can restrict a company’s ability to pay dividends because more cash may be required to repay the interest and principal on the loans borrowed. Companies with more manageable debt levels may find it easier to distribute dividends. 

• Growth Stage

A company’s growth stage is another factor affecting its dividend policy. If a company is in the initial stages of growth, it may focus on reinvesting its profits instead of distributing them. Conversely, when a company matures further and achieves a certain level of growth, it may have more freedom to distribute its profits to shareholders. 

The Importance of a Dividend Policy

A dividend policy is crucial for a company for various reasons. Here are some aspects that reiterate the importance of a dividend policy. 

• It ensures consistent returns for shareholders.
• It reflects the financial health and profitability of a company.
• It helps investors make informed decisions about holding or selling stocks. 
• It balances profit reinvestments and payouts for companies. 
• It gives investors a sense of assurance. 

Conclusion

The bottom line is that evaluating the dividend policy is crucial for investors with a long-term outlook. The importance of a dividend policy should not be overlooked, especially if you are planning to invest in companies that typically pay dividends. By factoring in the dividend policy, you can anticipate your future cash flows with more clarity. You should also be aware of any changes to the current dividend policy of a company, if any.

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