A portion of a company's net profits can be allocated to shareholders as a dividend, or kept within the company as retained earnings. Dividend payments are decided by the board of directors and must be approved by shareholders. These payments can be issued as cash or as shares of stock.
A dividend cut occurs when a dividend-paying company either completely stops paying out dividends (a worst-case scenario) or reduces the amount it pays out. This will often lead to a sharp decline in the company's stock price, because this is usually a sign of a company's weakening financial position, which generally makes the company less attractive to investors.
Why Dividends May Be Drastically Cut
Dividends are usually cut due to factors such as weakening earnings or a limited amount of funds available to meet the dividend payment. Typically, dividends are paid out from the company's earnings, and if earnings decline over time, the company will either need to increase its payout rate or access capital from other places, such as its short-term investments or debt, to meet the past dividend levels.
If the company uses money from non-earnings sources or takes up too much of the earnings, it may be putting itself into a compromising financial position. For example, if it has no money to pay off its debts because it is paying out too much in dividends, the company could default on its debts. But usually, it won't come to this, as dividends are usually near the top of the list of things cut when the company is faced with financial challenges.
This is exactly why dividend cuts are seen as a negative. A cut is a sign that the company is no longer able to pay out the same amount of dividends as it did before without creating further financial difficulties.