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 payment of dividends so far in this chapter, our attention has been concentrated, as is usually the case, on the relation between dividends and profits. It has been assumed that adequate and regular profits - provided they are correctly estimated - justify dividends. But this assumption must not be permitted to stand longer unchallenged. It is, in fact, the direct source of a large proportion of financial embarrassments. Thousands of corporations which have been able to report highly satisfactory profits and which have paid good dividends on the strength of those profits, have found themselves a short time later - to the intense surprise and indignation of their stockholders and even of their directors and officers - in the hands of their creditors. It is quite apparent that many business men, even including some of unusual capabilities, do not fully grasp the fact that dividend payments should be dependent not only upon profits, but also upon the corporation's cash position.
The point has already been emphasized and will later be reiterated, that many companies find their chief financial difficulties arising not in periods of depression and small business, but in their periods of prosperity. To attempt to do a large volume of business with a small working capital is one of the quickest and surest methods of financial hari-kari. Yet this is precisely the course that is followed by those concerns which, on the strength of a showing of profits, declare dividends, the payment of which seriously depletes their working capital. Under these conditions the only prudent course is to withhold dividends until in the normal course of the company's business cash is accumulated beyond the requirements of the business. It is not merely a book surplus, but in addition a satisfactory cash balance, that should furnish the basis for a declaration of cash dividends.
To give a concrete illustration of a situation which does not justify cash dividends, we may take the case of a flour mill company operating in Canada which has outstanding capital stock of $1,000,000. During a recent year the company reported net profits available for dividends amounting to $91,462, and declared dividends of $30,000, or 3%, leaving an addition to the surplus of $61,462. On the face of it there would seem to be no reasonable question as to the conservatism of this small dividend declaration. When we come to examine the company's balance sheet after payment of the dividend, however, we find that it shows a secured overdraft at its bank of $191,000. Its cash on hand is less than $6,000, and its cash and receivables together are less than its current liabilities. A glance at this balance sheet is enough to prove that the payment of dividends was not merely unwise, but a thoroughly reckless and dangerous proceeding.
Another example, which indicates clearly the results to stockholders of carelessness in figuring on cash requirements for dividends, is furnished by the history of the New England Cotton Yarn Company which was in existence from 1899 to 1903. During these four years the company was earning sufficient profits out of which to pay preferred stock dividends and actually paid these dividends, amounting in the aggregate to $1,212,500. During the four years cash fell approximately, from $2,000,000 to $500,000; notes payable which had been at one time reduced to as low as $650,000, rose before end of the four years to over $2,000,000. The inevitable result was receivership. Without the heavy outgo of cash dividends this might have been avoided. Even the preferred stockholders who received the dividends were heavy losers by this policy; although they received $24.25 a share in dividends, the market value of their stock went down from $105 to $25.*