Dividends from company profits help shareholders earn money regularly. How much do companies pay, and how do they decide dividend amounts? This guide explains what residual dividend policy means and how it works – companies first use profits for business needs, then share leftover earnings as dividends.
Understanding this will help companies make better decisions when sharing profits with investors. This article will help you gain clarity on this dividend type that balances business growth and shareholder returns.
What is a dividend?
Companies often distribute a portion of their revenue to their shareholders and owners as a dividend. A company has two options for using its retained profits when it makes a profit: reinvesting the money or paying dividends to shareholders.
The dividend yield is calculated by dividing the yearly dividend per share by the current share price.
That said, not all stocks pay dividends. Dividend stocks should be your first choice if you are investing in profitability. Stocks of companies that have a history of increasing their dividend payments tend to be more stable than the market.
In addition, dividends provide a regular source of income, which helps minimise the impact of fluctuations in stock prices.
Also read: Dividend Rate vs. Dividend Yield
What is the residual dividend policy?
The dividends given to shareholders are determined by the earnings that remain after the business has covered its capital expenditures and working capital requirements. This kind of payout is known as a residual dividend.
If a company has a residual dividend policy, it means that it will use its available revenues to finance capital expenditures before distributing dividends to shareholders. This implies that investors get a different dividend every year.
Businesses that pay out dividends in addition to their regular income have no extra funds on hand. The company reinvests any surplus funds or gives them to the shareholders.
Because the capital market isn’t perfect, companies don’t usually just follow a leftover payout strategy. Companies pay dividends regularly based on their past and current profits, a practice known as a smooth dividend policy.
Residual dividend policy payout ratio
The dividend payout ratio is the proportion of a business’s net income that pays dividends to stockholders. It is the portion of revenue distributed to stockholders as dividends. It is also known as the payout ratio.
The dividend payout ratio in a residual dividend policy is the proportion of net income that remains after paying for operating and capital expenditures.
The residual dividend policy payout ratio shows what percentage of profits go to paying out dividends to shareholders and what percentage goes towards reinvestment.
Also read: What are interim dividends?
How does a residual dividend policy work?
Dividends are distributed equitably to all shareholders belonging to the same class, like common, preferred, and others, with the value of the dividend determined per share.
The following are the stages of its operation:
- A portion of the business’ profits go towards retained earnings.
- Instead of reinvesting all of the profits, the management team decides to give away a portion of the additional revenue to the investors.
- The board has approved the anticipated payout.
- The dividend (with its value per share, payment date, record date, etc.) is announced by the business.
- Dividends are distributed to stockholders.
Residual dividend policy formula
The formula for the residual dividend policy is:
Dividends = Net income – (target equity ratio x total capital budget)
This formula shows how much of the net income is paid out as dividends after meeting the company’s capital budget needs. In a company’s capital structure, the target equity ratio is the ideal percentage of equity. The total capital budget is the funds needed for the company’s investment projects.
Example of residual dividend policy
Let’s say XYZ Ltd. has a share capital of ₹10,000,000 to understand the residual dividend policy. The company wants to maintain a 50-50 debt-equity ratio.
Here’s how the residual dividend policy and payout ratio will turn out in different scenarios depending on the company’s net income.
| Case | Net income (₹) | Equity (₹) | Dividends paid | Payout ratio |
| 1 | 6,000,000 | 5,000,000 (50% of ₹10,000,000) | ₹1,000,000 (6,000,000 – 5,000,000) | 16.67% (1,000,000/6,000,000) |
| 2 | 7,000,000 | 5,000,000 | ₹2,000,000 (7,000,000 – 5,000,000) | 28.57% (2,000,000/7,000,000) |
| 3 | 4,000,000 | 5,000,000 | ₹0 | 0% |
Also read: A guide to stock dividend
Advantages and disadvantages of residual dividend policy
The residual dividend policy comes with the following advantages:
- The cost of capital and flotation expenses are minimised since lower-cost retained profits are used to their maximum potential.
- It keeps you from getting the negative signs that can come with stock issues, like when the price is too high, or the company is having financial difficulties.
The residual dividend policy has the following drawbacks:
- It causes dividend payouts to be unpredictable and volatile, depending on the firm’s cash flow and capital needs.
- Investors get mixed signals about the company’s prospects due to this.
- Investors with a preference for a certain dividend payout ratio are likely to be interested in something other than it.
- It causes the required return on equity to go up, which cancels out the savings from reduced flotation costs.
These drawbacks make the annual implementation of the residual dividend policy by publicly-owned companies highly unlikely. The residual dividend policy, on the other hand, takes into account the investment opportunity circumstances and the normalised cost of capital to determine the firm’s long-term dividend policy.
Conclusion
With a residual dividend policy, businesses may satisfy both their costs and their shareholders.
However, if residual earnings are low, your payoff can be less than anticipated. One way to lower that risk is to invest in companies that use both fixed or steady income methods and a residual payout policy.
