the impact of changes in dividend strategy on ratio results

10.4 Finance and Accounting Strategy – Dividend Strategy and Ratio Analysis

Objective

Enable students to:

• extract the quantitative information required for ratio analysis from an annual report;
• explain how a change in dividend policy influences *all* major families of financial ratios;
• interpret the strategic implications for shareholders, creditors, management and other stakeholders;
• recognise the inherent limitations of ratio‑based analysis and how they can be mitigated.

1. Dividend‑policy options required by the syllabus

2. Using the annual report – linking each statement to the ratios you will calculate

1. Statement of Profit or Loss (Income Statement)
   • Profit after tax (PAT) → EPS, Dividend Payout Ratio, Retention Ratio, ROE, ROCE.
   • Operating profit → Interest Cover, Operating Margin.
   • Interest expense → Interest Cover, Debt Service Coverage.
2. Statement of Financial Position (Balance Sheet)
   • Total assets, current assets, inventories → Current Ratio, Quick Ratio, Asset Turnover.
   • Total equity (share capital + retained earnings) → ROE, D/E, Equity‑base for the Retention Ratio.
   • Total debt (short‑ and long‑term) → D/E, Debt Service Coverage, Solvency ratios.
3. Statement of Cash Flows
   • Cash generated from operating activities → Cash‑flow Coverage Ratio, liquidity analysis.
   • Dividends paid (financing section) → Direct input for Payout Ratio, DPS, Yield.
4. Notes to the Accounts
   • Accounting policies, contingent liabilities, tax rates → help explain anomalies in ratios.
5. Management Discussion & Analysis (MD&A)
   • Future financing plans, growth projects, dividend intentions → contextualise trend analysis and benchmarking.

3. Ratio families – strategic relevance to dividend decisions

4. Ratios that change *directly* when dividend policy is altered

1. Dividend Payout Ratio – proportion of PAT paid as dividends.
2. Retention (Plow‑back) Ratio – proportion of PAT retained for reinvestment.
3. Dividend per Share (DPS) – total dividends ÷ number of shares.
4. Dividend Yield – DPS ÷ market price per share.
5. Earnings Per Share (EPS) – $\displaystyle \frac{\text{PAT}}{\text{Shares outstanding}}$ (dividends are *not* deducted).

5. Additional ratios that are *indirectly* affected

• Current Ratio, Quick Ratio and Cash‑flow Coverage – cash outflows for dividends reduce the numerator.
• Debt‑to‑Equity and Interest Cover – equity falls when retained earnings are low; external borrowing may be needed.
• P/E Ratio – market price reacts to dividend signalling, altering the denominator of the ratio.
• Market‑Value‑Added (MVA) – $MVA = \text{Market value of equity} - \text{Book value of equity}$; a lower book value (because of smaller retained earnings) can increase MVA if the market price stays high.

6. Formulae (LaTeX notation)

7. Illustrative multi‑year example

XYZ Ltd. – figures extracted from the 2024 annual report (all amounts in £). The company has two possible dividend policies:

• Scenario A – 25 % payout (stable dividend).
• Scenario B – 50 % payout (high‑payout policy).

*Figures are illustrative; they are used only to compute liquidity and interest‑cover ratios.

7.1 Calculated ratios – Scenario A (25 % payout)

7.2 Calculated ratios – Scenario B (50 % payout)

Notes:

• Average equity = (beginning equity + ending equity) ÷ 2. Ending equity = beginning equity + retained earnings (PAT – Dividends).
• Current Ratio = Cash + Other current assets ÷ Current Liabilities (illustrative cash figures above).
• Cash‑flow Coverage = Cash from operating activities ÷ (Interest + Principal repayments). For simplicity, principal repayments are assumed to be £0; only interest is shown.
• Interest Cover = Operating Profit ÷ Interest Expense.

8. Interpretation of the multi‑year results

• Payout & Retention – Scenario B doubles the dividend, halving retained earnings. The firm therefore has less internal finance for future projects.
• Dividend Yield – Higher payouts raise the yield, making the share more attractive to income‑seeking investors, but the increase is partly offset by a modest rise in market price.
• EPS – Identical in both scenarios because dividends are not deducted from profit. Market reactions to the dividend announcement can still move the share price, influencing the P/E ratio.
• ROE – With the same PAT, a lower equity base (high payout) pushes ROE slightly higher, which may be interpreted positively by shareholders but can mask the loss of retained capital.
• D/E Ratio – As equity erodes, D/E rises marginally, signalling higher financial risk to creditors.
• Liquidity – Cash outflows for dividends reduce cash balances, causing a small fall in the Current Ratio (from 0.71 to 0.67 in the illustrative numbers). In a cash‑tight business this could become a material concern.
• Interest Cover & Cash‑flow Coverage – Because operating profit is unchanged, these ratios remain stable, but if the firm had to fund a growth project with external debt, the cover ratios would deteriorate.
• Market‑price ratios (P/E, MVA) – Assuming the market price follows the trend shown, the P/E ratio falls slightly under Scenario B (higher dividend → higher price → lower P/E). A higher MVA can arise if the market continues to value the firm above its reduced book equity.

9. Strategic considerations for managers

1. Trade‑off analysis – Weigh the immediate benefit of rewarding shareholders against the long‑term need for internal financing, a strong balance sheet and flexibility to invest.
2. Business lifecycle
   • Start‑up / high‑growth – favour residual or hybrid policies; retain earnings for capital‑budget projects.
   • Mature, cash‑generating – stable or progressive dividends can signal confidence and attract income investors.
3. Signalling theory – An increase in dividend is interpreted as a positive signal about future cash flows; a cut may be read as distress, depressing share price and increasing cost of capital.
4. Capital‑structure interaction – A high payout reduces equity; if growth opportunities exist, the firm may need to raise debt, raising D/E and lowering interest cover.
5. Stakeholder perspective
   • Shareholders – focus on dividend yield, payout ratio, EPS growth, and P/E.
   • Creditors – monitor liquidity, interest cover and gearing; a high payout can raise concerns about repayment capacity.
   • Management – must align dividend policy with overall financing strategy (10.2), investment appraisal (10.3) and any loan covenants.
6. Regulatory / tax considerations (UK) – Dividends are taxed at the shareholder level (dividend allowance, basic‑rate, higher‑rate bands). A higher payout may reduce the amount of profit available for tax‑efficient reinvestment.
7. Benchmarking & trend analysis – Compare the firm’s ratios with industry averages or key competitors to assess whether the chosen dividend policy is appropriate relative to peers.

10. Limitations of ratio‑based analysis (and how to mitigate them)

• Different accounting policies – Depreciation methods, inventory valuation (FIFO/LIFO) and revenue recognition can distort profitability and efficiency ratios. Mitigation: read the notes to the accounts and, where possible, restate figures to a common basis.
• One‑off or extraordinary items – Large gains/losses in a single year can inflate or depress PAT, EPS and ROE. Mitigation: use adjusted profit figures or exclude the item when calculating trends.
• Seasonality & timing differences – Cash‑flow ratios may be misleading for businesses with strong seasonal peaks. Mitigation: analyse quarterly data or use average balances over the year.
• Market‑price volatility – P/E and dividend yield depend on share price, which can be affected by market sentiment unrelated to fundamentals. Mitigation: look at longer‑term average prices or use price‑earnings‑to‑growth (PEG) ratios.
• Ratios are static snapshots – They do not capture future strategic plans, upcoming capital projects or changes in the macro‑environment. Mitigation: combine ratio analysis with MD&A commentary and forward‑looking forecasts.