The Danger of Dividends

Dr Ajibola Awolowo

Just before you call for my head, I ask that you kindly read this article. I also like the ringtone whenever I get a credit alert. I certainly like receiving dividends from companies I invest in but I am also aware of the possible downsides when dividends are blindly pursued. These downsides are what this article aims to highlight plainly.

Dividends are cash payments made out to all shareholders of a company which represent a portion of the profits made in a financial period. The total amount paid to each shareholder depends on the number of shares he or she holds. Dividends provide a source of passive income for investors as they staked their capital in the company which the company rewards by paying a dividend.

Companies that pay a regular and growing dividend are investors delight. Their shares are in high demand leading to relatively high share prices. Companies that do not pay dividends or pay a meagre dividend, on the other hand, are largely ignored by the market. Companies that break ranks by reducing dividend payments will suffer a serious decline in their share price as a direct consequence. Just ask one of the top five banks in Nigeria.

Metrics such as dividend yield and dividend pay-out ratio have been developed to better evaluate dividends. The dividend yield is dividend declared divided by the share price and expressed as a percentage while the pay-out ratio is the dividend declared divided by the earnings per share expressed as a percentage as well. Investors generally love companies with a high dividend yield and pay-out ratio.

To understand how dividends can pose a threat, we need to first understand how the cash used in paying dividends are gotten. Every company uses their assets, which can include physical buildings, computers, farmlands, cars, intellectual property, to generate revenues. The process of revenue generation however comes at a cost. They need to pay staff and keep their property/ machinery in working order. In addition to this, the company also needs to pay a tax to the government each year.

When the costs of production, cost of maintaining or replacing assets and the taxes are deducted from the revenue, the left-over funds are regarded as the profit after tax. It is from this sum that the company management decides on a percentage to pay-out to shareholders as dividends. The remaining portion is kept in the company to fund company growth.

Most investors think that the profit after tax declared after a financial period is sat in the company’s bank account just waiting to be spent. In reality, this is far from the truth. The cash that sits in the company’s account at the end of each financial period is very different from the profit or the loss declared for that period.

Why is this so? This can only be fully understood if we take a journey through the cashflows of the business and not remain fixated on its income statement. A good percentage of the sales made by the company are made on credit. Trusted and time-tested customers take the finished goods from the company inventory and pay for them, sometimes, as much as 90 days later.

The company however records this sale on their income statement as revenue earned in that period. To illustrate this, a company produces finished goods which it sells to its customer for N100,000.00 on December 29th on credit. The customer promises to pay in 90 days. For the financial year which ends on December 31st, the company records a revenue of N100,000.00 for this sale. This sale, however, is not backed by cash and is reflected on the company’s balance sheet as a receivable.

Just as some revenue on the income statement is not backed by cash inflows, some expenses are also not backed by cash outflows. These include depreciation & amortization. Depreciation is a cost incurred on assets as they gradually age due to wear and tear while amortization is a gradual write-down of the cost incurred in purchasing an asset.

Both of these items are charged yearly to the income statement but no physical cash is spent in the current financial period for them. Even though, they are charged as an expense, no cash leaves the bank account of the company for them.

These non-cash backed income/ expenses distorts the correlation between the profit after tax and the amount of physical cash sat in the company’s account. The profit after tax can therefore be manipulated by unscrupulous management teams to be as large or as small as they want it to be. All they have to do is increase inventory sales on credit or reduce the depreciation/ amortization figures for a particular accounting period to have a larger PAT and vice versa to reduce the PAT. Cash, on the other hand, is more difficult to manipulate.

How then can we, as personal investors, assess the cash position of companies and their capacity to pay a dividend from it? For this, we need to dive into one of the generally less understood parts of the financial statements – Statement of Cashflows and the concept of Free cash flow.

The statement of cashflows is divided into 3 broad parts – cashflow from operating activities, investing activities and financing activities.

Cashflows from operating activities takes the profit after tax from the income statement, adds all the non-cash expenses and account for changes in working capital. At the end of this section, the company records the net cash generated from operating activities.

Next, the company looks at all the purchases or sales of assets done in that financial period to determine the net cash generated from investing activities. It is a positive figure when more assets were sold than bought and negative when more assets were bought than sold.

Finally, the company accounts for cash used to finance its activities. Cash outflows for this will include dividends paid out in the financial period and repayments of debts while inflows will be new debts incurred or proceeds of any equity sale. This generates the net cash from financing activities.

Free cash flow on the other hand represents the amount of cash that can be safely withdrawn from the account of a company without compromising its operations and its future growth. This is calculated by subtracting money spent on purchasing new property, plant or equipment (seen as a line item under “Cash flow from investing activities”) from the net cash generated from operating activities.

The company management then decides how best to deploy this free cash. It can be used to pay a dividend, pay up its debt or buy back stock. In industries that have strong regulators, like the banking industry, companies are forced to only pay dividends from the free cash generated in a financial period. This should however be the ideal for every company.

If a company is paying a dividend which exceeds its generated free cash for the same period, it means it is dipping its hands into its reserves or equity to pay that dividend. Let’s take a practical example to illustrate all what we have talked about.

For the financial year ended December 31st 2021, Nestle Nigeria generated a profit after tax of about N39.2 billion naira, EPS of N49.47, traded at N1,505 at year end and declared a total dividend of N60.5 for the entire year. This is a dividend yield of 4% and pay-out ratio of 122%. Without digging any further, it is obvious that Nestle, beyond profit generated in the financial year, had to dip into their cash reserves to pay-out this dividend. Nestle is a mature company so it can be argued that they are allowed to do this.

Dangote Sugar, for the same financial period, had a PAT of N29.78 billion naira, EPS of N2.45, share price of N17.6, dividend declared of N1.50. Dividend yield is therefore 8.5% and pay-out ratio of 61%. To further investigate this, net cash generated from operating activities was N60.5 billion and capital expenditure wasN26.9 billion which yields a free cash flow of about N33.6 billion. When calculated on a per share basis, free cash flow per share was N2.27. In terms of the free cash flow, their pay-out ratio was 66% which still leaves the company with enough cash to undertake other activities.

Due to the immense pressure on company management to pay an ever-increasing dividend by shareholders, management may fall into the trap of paying a dividend at any cost. Unscrupulous management teams may cut down on capital expenditures in a bid to boost the free cash flow just so that they can pay a dividend and not disappoint their investors. Unfortunately, this amounts to mortgaging the future to allow one enjoy the present.

While dividends are great and provide a source of cash flow for investors, we should be mindful of how the money used in paying this dividend is sourced. A company that has to borrow, cutdown capital expenditure or consistently dip into its cash reserves just to pay a dividend today may be mortgaging its future.

Beyond paying a dividend, the growth of the company and maintenance of its competitive advantage should be paramount on the minds of company management teams. Shareholders should learn to pursue the longevity of the company rather than kill the goose that lays the golden eggs for short term benefit.

Dr Ajibola Awolowo can be reached via this email:

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