Dividend Payout Ratio: a Worked Example

Shareholders rank behind lenders on a winding up, and a dividend moves value past that ranking while the business is still running. Money paid out cannot later be used to meet a repayment, and retained profit is the cushion between a bad year and a breach. For a lender, then, a distribution is a use of cash that does nothing for the business's ability to repay.

A payout policy is often set as a percentage of profit, because that is simple and shareholders can plan around it. It fits the business only in a year when profit and cash are close together.

Numerator and denominator must cover the same period, and that needs checking: dividends paid in the cash flow statement can relate to last year's profit, while a final dividend for this year may be declared and paid only after the year ends. Listed companies quote the figure per share, dividends per share over earnings per share, which gives the same answer when the share count is steady. A payout above 100% means the company distributed more than it earned in the period, drawing on earlier retained profits or other equity.

The last line is the lender's own. No standard defines it, and agreements that test distributions describe their cash measure in their own words. In an owner-managed company, dividends are also only one route out. Directors' loans, a shareholder current account, management fees and above-market salaries take the same cash, and in some private companies they are larger than the dividend. A lender counts them together.

A family-owned maker of bathroom vanities, constructed for this page like every figure in it, earns a net profit of US$4.0m. Its board pays 60%, as it has for years. This year debtors and stock absorbed much of the cash, so operating cash flow after interest and tax was US$3.1m. It spent US$1.2m on a new CNC router and repaid US$1.0m of its term loan. The family also drew US$0.6m through their current accounts.

On the accounts, a 60% payout in a profitable year raises no question. On the cash, US$2.1m reached the family by way of the bank's revolving facility. The bank has, without being asked, lent the shareholders their dividend against the security of the debtors and stock that absorbed the cash. If the build reverses next year, the revolver comes back down and the dividend was merely early. If it does not, the business has less equity and more debt than its accounts imply. The levels are the example's, not a market norm.

Company law sets a floor, and each of the three markets sets it differently. In the UK a company may distribute only out of profits available for the purpose, broadly its accumulated realised profits less accumulated realised losses. New Zealand uses a solvency test: the board must be satisfied that, after the distribution, the company can pay its debts as they fall due and its assets exceed its liabilities, and directors sign a certificate saying so. Australia's Corporations Act requires that assets exceed liabilities by enough to cover the dividend, that the payment is fair and reasonable to shareholders as a whole, and that it does not materially prejudice the company's ability to pay its creditors.

None of those tests looks at whether this year's cash paid for the dividend, and the vanity maker could pass any of them. That is the gap a lender's contract fills, through a covenant limiting distributions, a consent right or a distribution lock-up that holds cash in the business until a ratio is met. A dividend recapitalisation is the same transfer made openly with new debt.

DEFINED IN ONE PARAGRAPH → · OWNER DRAWINGS → · THE LOCK-UP →

The ratio bites at two moments. At origination, the lender's forecast has to carry the owners' actual habits rather than a tidy retained-earnings assumption, because a repayment schedule built on full retention is fiction if the family expects its income. In a distribution request, the reading turns on whether the profit has become cash, which is why the quality of earnings is read first and why a consent can come with conditions on timing, size or a minimum level of headroom after payment.

It also matters in how the borrower presents itself. A board that sets its dividend by reference to cash after capital spending, and can show the working, gives a lender much less to ask about than one that applies last year's percentage.

LOAN COVENANTS, EXPLAINED → · CASH FLOW ANALYSIS →