Companies share their profits with shareholders by paying them periodic dividends. Financing these dividends is always a chief concern for the corporation, because a profitable operation does not always result in sufficient cash to distribute a dividend. Depending on its liquidity and type of dividend declared, the corporation may have to borrow money to afford a dividend payment.
Cash vs. Stock Dividends
Companies can pay dividends in the form of either cash or additional shares. When a company declares and distributes a cash dividend, a specific amount of cash for each unit of stock is deposited into shareholders' accounts at brokerage firms. If the company does not have sufficient cash on hand to distribute the previously announced sum to shareholders, it may have to borrow funds to honor the dividend payment. On the other hand, a corporation never has to borrow money to distribute a stock dividend. Since it does not cost any money to issue and distribute new shares to existing stockholders, a pure stock dividend does not necessitate new funds.
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Profitability vs. Liquidity
The reason a profitable company may have to borrow cash if the amount payable as dividends is smaller than the net profit for the same period lies in the difference between profitability and liquidity. A corporation is profitable if it grows its asset base. If the company has more buildings, equipment, vehicles and inventory at the end of the year without a rise in debt, it must have registered a profit. This does not mean, however, that the firm has more cash. The company may have invested the income in new equipment, for example, to grow its operations, and may have less cash on hand than a year ago, despite a very profitable year. Companies that lack cash are said to be illiquid. If a company has been profitable but is illiquid, it may have to borrow money to pay a dividend.
A company may have to borrow money to pay dividends if it has had unforeseen expenses between the declaration and distribution of dividends. Especially in large public corporations, there is usually a substantial lag between announcing and paying dividends. A corporation may declare a dividend in January, payable in April, for example. If an unexpected expense in March sucks up a huge amount of cash, the company may have to borrow money to honor the dividend obligation to its shareholders. Once declared by the board of directors, the upcoming dividend payment becomes a legal obligation.
Lack of Profits
A company may have to borrow money to pay dividends simply because it has not made enough money over the recent year to cover its dividend expense. Companies that have a long-standing dividend policy have shareholders who depend on these stable dividends for living expenses. Companies commonly insist on continuing to pay these dividends even if they had a bad year. Doing so may naturally require borrowing money. A corporation cannot keep paying dividends forever, in the absence of profits, of course, but if the management expects profits to return to normal, it may decide to bridge the short-term gap with a loan instead of altering a long-standing policy.