Investments in stock markets usually have two ways of providing returns to investors. They are via dividend payments (cash or script) or through capital appreciation. Whilst the latter depends a lot on the forces of demand and supply the former relies solely on the decision of the company. The board of directors of a company have the sole discretion of proposing dividend payments for any given financial year. As a shareholder, the only power you have as regards dividends is to approve or reject it or reduce it (You can’t even increase it).
However, there is also one very important factor that affects the decision on whether to pay cash dividends. That important factor is the Revenue Reserve. The revenue reserve or retained earnings is the cumulative profits of the company for prior years as well as that of the most recent profitable year. It is also called distributable profits and is where dividend payments are paid out from. Revenue reserves can be found in the financial statements of companies under the column where you have shareholders funds (Net Assets). They are usually stated after the Issued Capital and Share premium.
The Issued Capital or Premium of a company is non-distributable. Think of it the capital which you used to start a business which you very well know cannot be distributed as profits. The revenue reserve on the other hand is the balance left of your profits after you have paid yourself some dividends. For example Company A makes a profit of N1m, N2m, N3m, N4m for 2009, 2010, 2011, 2012 respectively. It has a policy of distributing 50% of its profits as dividends for any given year. It’s retained earnings (or revenue reserves) at the end of 2012 will be N5million.
Why is Revenue Reserve very important to dividends
Using the example above, supposing the same company has a very bad 2013 and the company makes a loss of N1million. Their revenue reserves reduces to N4million. The company can however still declare dividends because it still has a distributable reserve of N4million. The revenue reserve is distributable because it is still positive despite making a loss in the current year.
If however the company had an even worse 2013 and made a loss of N6million, the revenue reserve will go into negative N1million. As such the negative reserves becomes non-distributable because attempting to pay dividends from a negative reserve is the same as paying out of capital. Even if in the next year the company makes a profit of N1million or less they will still be unable to pay any cash dividends because they do not have any distributable profits. It will only declare dividends when the profits made during the year returns the revenue reserves to above zero.
This is why I have often regarded revenue reserves as one of the key ingredients that determine my investment decisions. If you are therefore an investor that likes to receive dividends then avoid investing in companies that have negative revenue reserves.