In this article, I'd like to talk about firms' dividend policy. So let's think about dividends for a moment let's consider this as a pool now when a firm has equity and they have profits this equity pool is expanded.
So let's say this equity is $100 and then the firm has $25 in net income. Now the pool of equity has been expanded. From these profits, the firm could theoretically pay a dividend. It could distribute this to shareholders and shareholders would get that money. Now, what would happen? Shareholders would be happy, everyone's happy to get paid money, and what would happen to the firm? well sent issuing a dividend is a positive signal, that's a credible signal to the market that the firm is is financially healthy that things are going well. You're signaling to "Hey we have enough money we can actually give it to shareholders. If the firm was struggling you might not be able to do that. So it's a positive signal to issue a dividend.
You're giving some of the profit back to shareholders. The question is well if that's the case then why don't firms pay out all their earnings as dividends? Why don't they take this entire 25 and give that to shareholders? Because in practice we don't find that to be the case, we don't find that a firm has $100 in net income and they say okay we're just going to give you that $100, it doesn't work like that. Of course, a firm is free to do that and in some cases maybe that does happen but for the better part of the time, firms do not pay out all their earnings as dividends and in fact, in some cases, firms don't pay out any of their earnings as dividends or maybe they just pay out a small amount as dividends. So I'd like to think about why this is the case? Why wouldn't a firm take all of that $100 or 25 and just give it to to the shareholders? Why wouldn't they do that?
Among some important reasons one reason is the dividends, if you pay them out in especially in terms of cash which most dividends are now you've lost that cash, and firms want to be able to expand they want to grow. So the money that has made those profits can be used to finance growth. If you have ten supermarket stores and they're going well and you get some profits you might say "Well now I want to have another ten stores. I want to grow. I want to make even more money." but to get this expansion instead of just asking shareholders or borrowing money from bondholders you can just take the profits and just pump them right back into the business. So you're reinvesting basically.
They're deciding that is best to reinvest these profits back into the firm so that we can grow. That's the best way we can use this money and therefore we're not going to issue a dividend.
There's also another reason that firms might not pay out every cent in earnings is a dividend is that they might have some kind of covenant some kind of agreement with a lender that may be "Our net worth won't decline below a certain threshold" so there's some kind of threshold for net worth and you know this is another word for equity so there's we've got a threshold for equity and say equity can't go below this certain amount. Let's think equity can't go below $2,000 or something and so when you actually are paying out a dividend remembers that you're decreasing equity. Dividends decrease equity you're paying out some of that equity back to the owners, back to the shareholders.
So if you pay out too much you might hit this threshold and then you're going to trigger a violation of a net worth covenant. So there are those kinds of agreements and stuff that the firms have in place with their lenders and one of them a common one is this net worth covenant and other ones as well but the main thing is that there might be some reason that they would actually not necessarily legally become attracted not to pay it out but maybe they don't want to violate this agreement that they have with a lender.
So another reason that a firm might decide that "We keep some of the earnings" is to make sure they have enough money for next year's earnings. Because when you think about it they might have had a great year this year but what we got to think about next year. So if the firm has $100 in earnings and they just pay it all out this year and then next year maybe they have a loss and so they're not in a position that they don't have any earnings to pay out as a dividend so now they have to do what's called cutting the dividend and just as issuing a dividend or increasing the amount of your dividend are all positive signals cut cutting a dividend is a negative signal to the market.
This might be interpreted by some as that the firm is in distress. There's some kind of problem and so the last thing you want to do is start a panic and cut your dividend. So if you don't pay out all the money in this year, you save some it's almost like a cookie jar you store some of this money for next time around to make sure that if your dividend is 25 cents this year that next year even if you have a loss you'll be able to continue to pay that dividend instead of having to cut the dividend and sending a negative signal to the market.
Then kind of along the same lines you might want to keep reserves in order not just even if you're you're not having a dividend that you're worried about cutting but maybe just in general about losses, losses are obviously not a good thing. If you sustain too many then you have to start kind of eating into your savings. I think about it as a person if you lose your job you have to eat into your savings right? Because you no longer have any income and it's the same thing with a firm if a firm does not generate profit if it has losses then it has to eat into savings but if it's already paid out all of its savings in the form of dividend then it doesn't have any savings to eat into.
So as soon as the firm begins to incur losses even though the firm might be able to make a comeback and you just have one bad year two bad years but if it didn't store any reserves up then the firm will basically go under almost immediately so the I might say we're going to keep some of this cash we're not going to pay it all out in dividends in order if you know if there's a bad year a bad couple years we'll be able to sustain those losses and eat into our savings and continue as a business.
