Why is the cash position of a company important, when deciding to create a dividend policy?
Cash position can be defined as the amount of cash that an organization possesses at a certain point of time. In this case it is common to consider not only the cash itself, but also other liquid assets, such as marketable securities and cash equivalents, which can be easily converted into cash. In the majority of cases strong cash position signals that the company is able to finance its operations and to meet obligations, therefore it is perceived as a sign of financial health. However, excessive amount of cash can also suggest that the company is not using its cash resources effectively (Block, & Hirt, 2008).
Cash position is an important factor in shaping company’s dividend policy. As dividends represent a certain part of the profits that is being distributed to shareholders, dividend payment is usually a cash outflow. Therefore, it is important to consider the liquidity of the company before formulating its dividend policy. Thus, the stronger the cash position is and the more cash is available in the company, the easier it is to pay cash dividends (Periasamy, 2009). However, if there is a mismatch between company’s income and its cash position that results in low liquidity, it is more appropriate to distribute stock dividends or no dividends at all. Although such policy may be unpopular among shareholders, it will allow the company to preserve its liquidity and to retain the cash needed for financing operations and debt.
Although cash position is an important determinant of the dividend policy, it is essential to consider this indicator in conjunction with the overall strategic orientation of the company and with the nature of the business. Thus, young companies need to maintain a sufficient cash reserve in order to finance further growth. On the other hand, mature companies can afford distributing more cash to its shareholders. Moreover, the stability of cash flows, current level of obligations, and the overall prospects in the industry may affect company’s dividend policy.
References
Block, S., & Hirt, G. A. (2008). Foundations of Financial Management. (12th ed.). Boston,
MA: McGraw Hill.
Periasamy, P. (2009). Financial management. (2nd ed.). New Delhi, India: Tata McGraw-Hill.
