Residual Dividend

What is a 'Residual Dividend'

A residual dividend is a dividend policy company management uses to fund capital expenditures with available earnings before paying dividends to shareholders, and this policy creates more volatility in the dollar amount of dividends paid to investors each year. The first priority is to use earnings to cash flow capital expenditures, and dividends are paid with any remaining earnings generated by the firm.

BREAKING DOWN 'Residual Dividend'

A company’s capital structure typically includes both long-term debt and equity, and a capital expenditure can be financed by taking out a loan or by issuing more stock.

How Companies Use Earnings

When a business generates earnings, the firm can either retain the earnings for use in the company or pay the earnings as a dividend to stockholders, and retained earnings are used to fund current business operations or to buy assets. Every company needs assets to operate, and those assets may need to be upgraded over time and eventually replaced. Business managers must consider the assets needed to operate the business and the need to reward shareholders by paying a dividend.

Factoring in Residual Dividends

Assume that a clothing manufacturer maintains a list of capital expenditures that are required in future years and that the firm needs $100,000 in the current month to upgrade machinery and buy a new piece of equipment. The firm generates $140,000 in earnings for the month and spends $100,000 on capital expenditures. The remaining income of $40,000 is paid as a residual dividend to shareholders, which is $20,000 less than was paid in each of the last three months. Shareholders may be upset when management chooses to lower the dividend payment, and senior management needs to explain the importance of capital spending to justify the lower payment.

Examples of Return on Assets

While shareholders may accept management’s strategy of using earnings for capital expenditures, the investment community analyzes how well the firm uses asset spending to generate more income. The return on asset (ROA) formula is net income divided by total assets, and ROA is a common tool used to assess management’s performance. If the clothing manufacturer makes smart spending decision with the $100,000, the company can increase production or operate machinery at a lower cost, and both of these factors can increase profits. As net income increases, the ROA ratio improves, and shareholders may be more willing to accept the residual dividend policy moving forward. However, if the firm generates lower earnings and continues to fund capital expenditures at the same rate, shareholder dividends decline.