What would happen to a company's external fund requirements if it reduces the payout ratio, or if it suffers a decline in its profit margin?

By Ken Clark AAA
A:

In short, the stronger the company's internal cash flow, and in turn cash position, the less the need to draw on an external fund. If internal cash flow or the retention ratio increases, external fund requirements would decrease. If internal cash flow suffers, external fund requirements will climb.

Specifically, if a company reduces its payout ratio, it means that it is retaining more money in shareholders' equity, which can be used, in turn, to meet funding needs. With all other things remaining equal, such as internal liabilities, this reduced dividend payout ratio would lower the external fund requirement.

Conversely, a decline in profit margin, assuming overall revenue stays the same, would translate into less internal cash. This would increase the overall funding need and raise the external fund requirement.

Often these two actions are counterbalanced. Companies not wanting to increase their external fund requirements will often decrease their payout ratio in response to long-term declines in profit margin. Of course, a move such as this can raise shareholder fears and frustrations, putting a downward pressure on the overall price of a stock.

For more, see Is Your Dividend At Risk? and The Importance Of Dividends.

This question was answered by Ken Clark.

RELATED FAQS

  1. What causes dividends per share to increase?

    Learn what the major factors are that can lead to changes in a company's dividend payouts and drive increases in dividends ...
  2. What causes dividends per share to decrease?

    Learn what dividend per share is, how it is calculated and reasons why a company may decrease or remove its dividend payment.
  3. Why would a company want to decrease its dividends per share?

    Learn what dividends per share are, how the ratio is calculated, what the payout ratio is, and why a company would lower ...
  4. Why doesn't Berkshire Hathaway pay a dividend?

    Learn why Berkshire Hathaway, despite being flush with cash, does not pay dividends and how its CEO feels that not paying ...
RELATED TERMS
  1. Dividend

    A distribution of a portion of a company's earnings, decided ...
  2. Target Payout Ratio

    A target payout ratio is a measure of what size a company's dividends ...
  3. Policyholder Dividend Ratio

    The policyholder dividend ratio is a measurement of the profitability ...
  4. Paid-Up Additional Insurance

    Additional whole life insurance that a policyholder purchases ...
  5. Accelerated Dividend

    Special dividends paid by a company ahead of an imminent change ...
  6. Sucker Yield

    When an investor has essentially risked all of his capital for ...

You May Also Like

Related Articles
  1. Stock Analysis

    How Realty Income Became A Top Dividend ...

  2. Trading Strategies

    American Express: Headwinds and Tailwinds

  3. Stock Analysis

    Playing Small-Caps In This Market? The ...

  4. Fundamental Analysis

    Lessons On Corporate Dividend Payout ...

Trading Center