This section is from the book "Business Finance", by William Henry Lough. Also available from Amazon: Business Finance, A Practical Study of Financial Management in Private Business Concerns.
In discussing the desirability of establishing and maintaining a regular rate of dividends it has been suggested that the only safe principle to follow is to fix the dividend rate below the estimated minimum earnings, thus making sure that it will be kept up year after year. This leaves all the extra profits of good years to go into surplus. If the company's business is of a highly stable nature so that the fluctuations in earnings are slight, it follows that the extra earnings of the good years will be relatively small and surplus will accumulate slowly. If the business, on the other, hand, fluctuates a great deal, these dividends will absorb only a small proportion of average earnings, and the greater portion will remain as a credit to the surplus account.
This principle, therefore, automatically results in piling up a surplus almost in direct proportion to the degree of fluctuation of earnings. And this is as it should be. A company engaged in a business which enjoys steady earnings will have no trouble in raising fresh capital for any extensions that may be required and which can be shown to be clearly profitable. It is not necessary, therefore, that new capital should be provided by savings out of earnings. On the other hand, a company, the earnings of which fluctuate widely, is, on the face of it, engaged in a speculative business and cannot easily secure fresh capital on favorable terms. Only through accumulations out of earnings can the business be extended and stabilized.
The principle that has just been stated is, of course, put forward only as a general rule which is subject to innumerable qualifications and exceptions. First of all, it may be impossible to determine in advance what the minimum earnings are likely to be. Second, it may be desirable to use some discretion and diplomacy in dealing with stockholders and to satisfy their wishes from time to time by distributing a portion of the extra earnings of prosperous years. For both these reasons the strict and inflexible application of the rule that has been stated is not always to be insisted upon. Most well-managed companies are satisfied if they reach some reasonable approximation in applying the rule.
There is another qualification, also, of still greater importance. In all that has been said as to this rule, it has been taken for granted that fresh capital can be taken into any business enterprise and used as profitably as the original capital. In a great many cases this is true, especially if the fresh capital is not dumped upon the company in one or two big lots secured through the sale of securities, but is gradually added year after year and thus made available for betterments and extensions that are actually needed. However, even in those cases there may, after a time, come a limit to the development of the company beyond which fresh capital cannot be profitably applied. When this limit is reached, it is no longer desirable to accumulate surplus with rapidity. If earnings have not at that time been stabilized, it may be good policy to pay out most of the income year after year in dividends, allowing the dividends to fluctuate in close relation to the income. Or it may be adjudged better to fix the dividend rate at about the average anticipated income, in which case extra profits of the good years will be invested outside the company in short-term securities which will be sold when necessary in order to provide cash or dividends during the lean years. It is perhaps due to the fact that opportunities for expansion of most successful enterprises in the United States are almost unlimited, that so much emphasis has been laid in our financial practice on the necessity of making large savings out of annual profits; whereas in European countries, where the opportunities for expansion are more limited, the custom prevails of paying out most of the annual earnings in dividends and of relying upon fresh issues of securities to provide whatever new capital is needed.